During the summer of 2021, the Internal Revenue Service finalized the filing requirement for two new schedules intended to provide consistent reporting of international tax-related information to partners and shareholders. This includes certain international income, deductions, credits, and miscellaneous items for pass-through entities (Partnerships and S-Corporations) and those who file Form 8865 (Return of U.S. Persons with Respect to Certain Foreign Partnerships) for returns covering the 2021 tax year and beyond. These schedules are K-2 Partner’s Distributive Share Items – International or Shareholder’s Pro-Rata Share Items – International; and K-3 Partner’s Share of Income, Deductions, Credits, Etc. – International or Shareholders’ Share of Income, Deductions, Credits, Etc. – International.
The Tax Cuts and Jobs Act of 2017 increased the amount and types of information needed to calculate tax liability for international tax-related items. While most of the information to be reported on the new schedules was already required to be included on Schedules K and K-1 of an entity’s tax return, the new schedules will require more detail and additional time when preparing the return. The schedules are intended to provide the consistency and transparency needed to alleviate difficulty in determining and applying the proper treatment of these items by partners and shareholders. Given the level of detail required, a substantial amount of time and resources will be needed to collect, analyze, and report the required information. An entity will need to have appropriate processes and systems in place for this purpose.
As of this writing, the IRS has promised to provide full details on transition relief for Schedules K-2 and K-3 reporting for certain qualifying domestic partnerships and S-Corporations. For 2021, this relief would apply to entities with no foreign activities, no foreign partner or shareholder, and no knowledge of any partner or shareholder needing information on items of international relevance. This means that these entities would not have to file the new schedules for 2021. However, if a partner or shareholder subsequently notifies the partnership or S corporation that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder.
While the transitional relief is good news for entities that qualify, the same cannot be said for those entities that will need to file the Schedules for 2021. The IRS has noted that the Schedules will not be ready for e-filing until after the original filing deadline for calendar-year entities – which is March 15th. The estimated timeline for software development of the Schedules and the ability to e-file them is March 20th for Partnerships, mid-June for S-Corporations, and January 2023 for those filing Form 8865. Essentially, there are two options available. One is to prepare the Schedules as PDFs that can be attached to the return prior to e-filing and sending the return by the due date. The other is to file a request for an automatic extension of time to file the return and wait for the approved forms. This decision also has implications for preparing and filing the returns of partners and shareholders.
In addition to knowing whether your entity is required to file these Schedules, there are several things to consider regarding compliance with the new reporting requirements. These considerations include:
- Understanding what information and data must be collected, analyzed, and reported.
- Determining whether there are systems, processes, and procedures in place to collect, analyze and report the required information and data.
- Knowing the potential consequences or penalties for failure to file or to provide accurate and timely information.
- Demonstrating a good faith effort to comply with the new reporting requirements.
When are the schedules required?
The reporting requirement is straightforward for entities with foreign partners or shareholders, foreign source income, hold assets that generate foreign income, and/or pay or accrue foreign taxes. These entities must file Schedules K-2 and K-3. However, the reporting requirement also applies when there is a partner or shareholder need for information on international tax-related items. For example, suppose an individual partner or shareholder claims a foreign tax credit on Form 1116 Foreign Tax Credit (individuals, estates, trusts) or 1118 Foreign Tax Credit (Corporations). In that case, it is critical that they are provided with detailed information from all sources, both within and outside of the United States, to complete the form accurately.
What information and data are needed?
Completing the Schedules is not an “all-or-nothing” proposition. The necessary information and data are determined on a part-by-part basis with eleven different parts to each Schedule.
Concerning each part:
- Part I requires identification of current year international information such as gain on the sale of personal property, foreign oil and gas taxes, foreign tax translation, high-taxed income, section 267A disallowed deduction, Form 8858 information, Form 5471 Information Return of U.S. Persons With Respect to Certain Foreign Corporations, partner loan transactions, and the like.
- Part II covers the foreign tax credit limitation.
- Part III reports other information for the preparation of Form 1116 or 1118.
- Part IV covers information on the Section 250 deduction concerning foreign-derived intangible income (FDII).
- Part V reports distributions from foreign corporations.
- Part VI gives information on Section 951(a)(1) and Section 951A inclusions.
- Part VII shows the information needed to complete Form 8621 Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
- Part VIII reports information about the entity’s interest in foreign corporation income.
- Part IX provides information for base erosion and anti-abuse tax (Section 59A).
- Part X reports foreign partners’ character and source of income and deductions.
- Part XI focuses on information about Section 871(m) Covered Partnerships.
What penalties are associated with these Schedules?
The entity can be assessed four different types of penalties related to Schedules K-2 and K-3. These are:
- Failure to file or show information on the return or required form
- Failure to file correct information returns
- Failure to furnish the correct payee statements
- Failure to furnish information required under Section 6038 Information Reporting with Respect to Certain Foreign Corporations and Partnerships. These penalties are not insignificant in amount.
The penalty for failure to file or show information on the return or required form is currently $210 per partner/shareholder per month that the return is late or incorrect, up to a total of 12 months. The penalty for failure to file correct information returns is $270 per failure – which applies to the overall return and each Schedule (K-1 and K-3) for each partner or shareholder. The failure to furnish correct payee statement penalty is also $270 per failure and applies to the information required to be shown on the statement or to the inclusion of incorrect information on the statement. Finally, the failure to furnish information required under Section 6038 is $10,000 per failure, with a continuation penalty of $10,000 (not to exceed $50,000) for each 30-day period that begins after notification from the IRS about the penalty. This penalty will be imposed for failing to furnish information on Form 8865, Schedule K-1 (of Form 8865), and Schedules K-2 and K-3.
Is there any relief from penalty?
Abatement or other relief from penalties will not be automatic – the partners/shareholders of the entity will need to convince the IRS that a good faith effort was made to comply with the new reporting requirements. You can demonstrate good faith in attempting to comply with the new reporting requirements through documentation of the following:
- Changes to processes, systems, and procedures for collecting and processing the relevant information.
- Efforts to obtain relevant information from partners, shareholders, or members of the controlled foreign partnership, including any modification to the partnership or S-Corporation agreement.
- The reasonableness of assumptions made.
The purpose of the new schedules is to supplement the K-1 and provide consistent reporting of international tax-related information needed by partners and shareholders to prepare their tax returns properly. Entities should ensure that all partners and shareholders are properly documented with a W-8 or W-9, reviewing their 2021 transactions and determining whether the filing requirement applies.
While some transitional relief is available to qualified entities in 2021, those required to file the Schedules will have to determine the best course of action – whether to wait for finalized Schedules that can be completed and e-filed within tax software or to prepared PDFs that can be uploaded and attached.
As with any change in tax law or reporting requirements, it is advisable to seek guidance and advice from tax professionals. While the IRS continues to update its guidance on the preparation and filing of Schedules K-2 and K-3, it is incumbent upon officers of affected entities to not only understand the reporting requirements but to have systems, processes, and procedures in place to expedite the collection, analysis, and reporting of the requisite information and data.