Articles & Alerts
New Schedules K-2 and K-3 – What Investment Partnerships Should Know When Dealing with the New Requirements
In an effort to provide standardized reporting of items of “international tax relevance” to owners of pass-through entities, the IRS released two new forms to disclose foreign activities of partnerships and S corporations. Beginning with tax year 2021, pass-through entities with items of international tax relevance are required to file a Schedule K-2 and Schedule K-3 with their tax returns. Schedule K-2 is an extension of Schedule K and reports items of international tax relevance from the operations of the pass-through entity. Schedule K-3 is an extension of Schedule K-1 and reports each partner’s or shareholder’s allocation of these items. Partners and shareholders will use the information reported on their Schedule K-3 to complete the various forms related to international reporting on their own tax or information return.
How did we get here?
Private investment funds, including hedge funds, private equity funds and funds of funds, previously reported their items of international tax relevance through various forms, Schedule K-1 footnotes and whitepaper supplemental schedules, many of which were not standardized or similar in form. This has been a growing concern to the IRS as well as to the partners and shareholders receiving such statements and disclosures in varying formats. The new Schedules K-2 and K-3 provide pass-through entities with a standardized format for reporting U.S. international tax information to their partners or shareholders, including withholding and sourcing details for foreign partners and shareholders, as well as U.S. international items of relevance to domestic partners and shareholders. While this will result in better consistency and transparency in pass-through entities’ international tax reporting, a great amount of time and effort will be required to obtain the requested information, some of which may have not been previously maintained or disclosed.
What are items of “international tax relevance”?
While there is no concise definition as to what “international tax relevance” items are, there are references to the international tax provisions of the Internal Revenue Code in the Schedules K-2 and K-3 instructions. Examples of items of international relevance that must now be reported on Schedules K-2 and K-3 include, but are not limited to:
- Foreign tax credit related information including the sourcing and bucketing of income and deductions.
- Interests in foreign entities or distributions from foreign corporations.
- Foreign partner’s or shareholder’s U.S. source income and/or U.S. effectively connected income.
- Information related to investments in foreign entities (e.g., passive foreign investment companies), interests in controlled foreign corporations, global intangible low-taxed income (GILTI), subpart F income inclusions and foreign-derived intangible income (FDII).
For example, the new Schedule K-3 provides the information that corporate and individual partners need to calculate their foreign tax credit on Form 1118, Foreign Tax Credit — Corporations, and Form 1116, Foreign Tax Credit (Individual, Estate, or Trust), respectively. Even pass-through entities with only domestic income and assets may have to complete this section of the Schedules K-2 and K-3 if they have partners or shareholders that are claiming a foreign tax credit on their own tax or information return.
Adding to the challenges already faced by the tax community, on January 18, 2022, the IRS issued an online update to the Schedule K-2 and K-3 instructions stating that pass-through entities with no foreign activities may still have items considered to be of “international tax relevance” which would require a pass-through entity to file a Schedule K-2 and K-3. This late IRS update was met with criticism from tax professionals and owners of pass-through entities alike, with many believing it would be impractical and unrealistic to expect pass-through entities, previously under the impression that they would not have a filing requirement, to suddenly undertake the burdensome task of gathering information and preparing these new and complex schedules.
Is there any relief available?
In response to the above concerns, on February 16, 2022, the IRS provided an additional exception for tax year 2021 related to filing the Schedules K-2 and K-3 for certain domestic partnerships and S corporations. To qualify for this exception, the following must be met:
- In tax year 2021, the entity has no direct foreign partners, members, or shareholders.
- In tax year 2021, the entity has no foreign source activity.
- In tax year 2020, the entity did not report any foreign tax information and no partner or shareholder requested such foreign tax information.
- In tax year 2021, the entity has no knowledge that any of their partners, members or shareholders are requesting this information.
Note that if a member, partner or shareholder requests foreign reporting information prior to the filing of the tax return, the pass-through is obligated to include Schedule K-2 with its tax return filing and to provide Schedule K-3 to all partners, members or shareholders. However, if the request is made subsequent to the filing of the pass-through entity tax return, the entity is only obligated to provide Schedule K-3 to the requesting party.
If the tax year 2021 filing exception discussed earlier does not apply, nor do you meet the penalty relief provided in IRS Notice 2021-39, penalties may apply for filing Form 1065, Form 1120-S or Form 8865 without Schedules K-2 and K-3 where required. Late filing penalties of $210 per month, per partner or shareholder, in addition to a $280 penalty per partner or shareholder for failure to furnish information may apply if the schedules are not properly completed. If the reporting requirement is intentionally disregarded, an increased penalty may apply.
While the transition relief was welcome news to the tax community, the relief may be somewhat limited for investment partnerships that have partners that are themselves partnerships or are part of a tiered partnership structure. In such instances, it may not be possible for such partnerships to know who their ultimate investors are, and what tax information those investors would need and possibly request. As a result, it may be prudent for investment partnerships that appear to qualify under the transition relief to nonetheless prepare Schedule K-2 and issue Schedule K-3 along with Schedule K-1 to their investors, unless they are certain that none of their direct or indirect partners would need or request this information at a future date.
The forms are extensive and require an in-depth understanding of complex international tax concepts. Private investment funds that have international activities also face a unique challenge with this new reporting requirement, leading to an increased tax compliance burden for funds, investor-relations issues as well as timing issues related to the delivery of Schedules K-1 and K-3. Partnerships and S corporations should prepare for the upcoming filing requirement by ensuring their partners and shareholders are properly documented with a Form W-8 or W-9, by reviewing their 2021 transactions and by determining whether the new filing requirement applies. While the new schedules are a compliance burden for pass-through entities, they will aid pass-through entity owners in the filing of their own tax returns and assist IRS enforcement efforts with respect to international transactions.
For more information regarding your Schedule K-2 and K-3 reporting requirements and how the transition relief for the 2021 tax year may apply to you, please contact your Anchin Relationship Partner.