IRS issues draft instructions, provides penalty relief for new Schedules K-2 and K-3
On June 30, 2021, the IRS released early draft instructions for Schedules K-2 and K-3. These schedules, which are new for the 2021 tax year, are required to be filed with Forms 1065, 8865 and 1120-S of pass-through entities with “items of international tax relevance.” On the same date, the IRS issued Notice 2021-39 to grant transition period penalty relief for eligible taxpayers with respect to the new schedules. The IRS released final Schedules K-2 and K-3 on June 3 and June 4, 2021.
Schedules K-2 and K-3 and Draft Instructions
Schedules K-2 and K-3 are intended to replace, supplement and clarify the reporting of items of international tax relevance formerly reported on Schedules K and K-1 and to better assist in providing partners and shareholders the information necessary to accurately complete their returns. Items of international tax relevance generally include international activities and foreign partners.
Schedule K-2 is an extension of Schedule K and is used to report items of international tax relevance of the partnership or S corporation. Schedule K-3 is an extension of Schedule K-1 and is used to report a partner’s distributive share of items reported on Schedule K-2. All pass-through entities with items relevant to the determination of tax or certain withholding or reporting obligations of their partners or shareholders under U.S. international provisions must complete the appropriate parts of Schedules K-2 and K-3. In addition, Schedule K-3 must be furnished to partners and shareholders along with Schedule K-1.
The draft instructions provide detailed explanations and examples regarding the information required to be reported and who must file each part of Schedules K-2 and K-3. The schedules report, among other items, amounts and information necessary for:
- Calculating the foreign tax credit (FTC) limitation. The schedules report items of gross income and deductions (by source and category), foreign taxes paid or accrued and other adjustments;
- Allocating and apportioning interest expense, research and experimental expense and foreign-derived intangible income (FDII) deductions for purposes of the FTC limitation;
- Calculating the Section 250 deduction with respect to FDII;
- Determining the taxability of distributions from foreign corporations, including foreign currency gain or loss;
- Reporting income inclusions from controlled foreign corporations under the Subpart F and GILTI rules and from passive foreign investment companies, including deemed paid foreign taxes;
- Calculating the base erosion anti-abuse tax (BEAT); and
- Determining withholding tax and reporting requirements for transactions under Section 871(m).
The draft instructions also clarify that Schedules K-2 and K-3 require the partnership or S-corporation to attach statements to report certain information for all other items of international tax relevance not reported elsewhere on the schedules, including information regarding splitter arrangements, high-taxed income, Forms 8858 and 5471 information reporting, Section 267A disallowed deductions, dual consolidated losses and others.
Notably, the draft instructions state that for certain parts of the schedules the filer is expected to collaborate with the partners or shareholders (or the controlled foreign partnership) to determine the reporting requirement, and unless the Schedule K-2/K-3 filer has knowledge to the contrary, it must file or complete certain parts assuming that the information is relevant to the partner or shareholder.
Notice 2021-39 Penalty Relief
Notice 2021-39 provides transition period penalty relief with respect to Schedules K-2 and K-3. In general, the penalties that apply with respect to Forms 1065, 8865 and 1120-S and Schedules K and K-1 also apply with respect to Schedules K-2 and K-3 beginning in 2021. These include penalties for failing to timely file the schedules, for filing incorrect or incomplete schedules and for failing to furnish a correct Schedule K-3 to partners and shareholders.
Under Notice 2021-39, taxpayers will not be subject to the penalties described in the notice for Schedule K-2/K-3 reporting (and for furnishing Schedule K-3) for tax years that begin in 2021 if the taxpayer establishes to the satisfaction of the Commissioner that it made a good faith effort to comply with the requirements. In determining what is a good faith effort, the notice states that the IRS will consider the extent to which a Schedule K-2/K-3 filer has:
- Made changes to its systems, processes and procedures for collecting and processing information relevant to filing Schedules K-2 and K-3;
- Obtained information from partners, shareholders or the controlled foreign partnership, or applied reasonable assumptions when information is not obtained; and
- Taken steps to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that is relevant to determining whether and how to file Schedules K-2 and K-3.
In cases where information about the partners or shareholders is necessary to determine whether a part applies or how to report amounts, the penalties for incomplete or inaccurate reporting will not apply during the transition period if the filer establishes to the satisfaction of the Commissioner that it made a good faith effort to determine whether it must file a part and how to complete a part that it files. The notice states that the IRS will assess the effort the Schedule K-2/K-3 filer made to obtain this information and the reasonableness of any assumptions, taking into account the relationship between the filer and its partners, shareholders or the controlled foreign partnership. The notice also states that a Schedule K-2/K-3 filer may have made a good faith effort despite being unsuccessful in obtaining the information.
SHARE