Editor: Howard Wagner, CPA
On June 3 and 4, 2021, the IRS released final versions of two new international-related schedules that are being added to passthrough entity returns:
- Schedule K-2, Partners' Distributive Share Items — International; and
- Schedule K-3, Partner's Share of Income, Deductions, Credits, etc. — International.
Similar schedules have been released for S corporation returns, too. Schedule K-2 will report the partnership/S corporation-level activity attached to a flowthrough return, while Schedule K-3 will be provided to each partner or shareholder and report its proportionate amount for each item. Draft instructions for the new Schedules K-2 and K-3 were released on June 30, 2021.
The new international-related schedules will be required to be filed with 2021 partnership/S corporation returns and 2021 Schedules K-1, Partner's Share of Income, Deductions, Credits, etc.
Recognizing that the detailed new schedules will create transitional challenges, the IRS announced in Notice 2021-39 that it will provide certain penalty relief to filers who fall short of the new requirements in tax years that begin in 2021, so long as they make a good-faith effort to comply, as discussed below.
The new forms will create more clarity for shareholders and partners on how to calculate their U.S. income tax liability when considering potential international-related deductions, credits, and miscellaneous items. Although these forms contain a new level of detail, most of this information was already required to be included with previous Schedules K-1 as white paper attachments. With the Schedules K-2 and K-3, the information is now being required in a standardized format with an additional level of detail.
The forms consist of specific Schedules K-2 and K-3 for:
- Partnerships filing Form 1065, U.S. Return of Partnership Income;
- S corporations filing Form 1120-S, U.S. Income Tax Return for an S Corporation;and
- U.S. persons filing Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.
With respect to Form 1065, the following are the different parts of the Schedule K-2 form:
- Part I, "Partnership's Other Current Year International Information";
- Part II, "Foreign Tax Credit Limitation";
- Part III, "Other Information for Preparation of Form 1116 or 1118";
- Part IV, "Information on Partner's Section 250 Deduction With Respect to Foreign-Derived Intangible Income (FDII)";
- Part V, "Distributions From Foreign Corporations to Partnership";
- Part VI, "Information on Partner's Section 951(a)(1) and Section 951A Inclusions";
- Part VII, "Information to Complete Form 8621";
- Part VIII, "Partnership's Interest in Foreign Corporation Income (Section 960)";
- Part IX, "Partners' Information for Base Erosion and Anti-Abuse Tax (Section 59A)";
- Part X, "Foreign Partners' Character and Source of Income and Deductions";
- Part XI, "Section 871(m) Covered Partnerships"; and
- Part XII, "Section 871(m) Tax Liability of a Qualified Derivatives Dealer (QDD)."
Differences between versions
Drafts of the forms were first introduced on July 14, 2020. The IRS subsequently released updated draft forms on April 29, 2021, and then made available final versions on June 3 and 4, 2021.
With respect to Form 1065, a few key differences between the first draft of the Schedule K-2 and the final version are:
- On page 1 of the Schedule K-2, a prominent box has been added for the purpose of denoting which parts (I-XII) of the form are applicable. This will be helpful in identifying the important items for each partner. The form itself is 19 pages in its final form, so this can be seen as a helpful step in organization.
- In Part III of the Schedule K-2, the final version has removed the section detailing research-and-experimentation (R&E) expenses apportionment factors on a gross income basis. Consistent with the foreign tax credit final regulations issued Sept. 29, 2020 (T.D. 9922), apportioning R&E based on gross income is no longer an option. The foreign-derived intangible income (FDII) apportionment factors were also added.
- In Part IV of the Schedule K-2, a new section has been added: Section 1, "Information to Determine Deduction Eligible Income (DEI) and Qualified Business Asset Investment (QBAI) on Form 8993." Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), was revised in December 2020 and added several questions for 2021 reporting. The questions added to Schedules K-2 and K-3 are necessary additions to give the partner or shareholder the information needed to complete a Form 8993.
- In Part VI of the Schedule K-2, a new column has been added: "Ending of CFC Tax Year."
- In Part IX of the Schedule K-2, column headings have been added in Section 1 so that a breakout can be shown between gross receipts effectively connected with a U.S. trade or business (effectively connected income, or ECI) and non-ECI gross receipts in the total gross receipts taken into account in determining whether a taxpayer is an applicable taxpayer under Sec. 59A(e) and, if so, in calculating base-erosion payments.
How can a practitioner prepare?
Tax preparers use various types of software to prepare and distribute Schedules K-1 to partners. Although software is leveraged, most practitioners still need to gather specific information manually to input into such systems. Although most, if not all, of the information that will be needed on Schedules K-2 and K-3 is already required to be provided to partners, more detailed responses will be necessary for much of this information than at present. As many tax preparers know from their experiences in standardization of workpapers and tax return automation, the creation of such processes takes a tremendous amount of time and resources.
Numerous providers have made the switch to internally or externally developed software that provides for increased automation of Schedule K-1 creation and distribution. In the digital world, this creates efficiency on the preparation side and convenience on the recipient side. No longer does a K-1 provider need to spend as much time with detailed data entry, and no longer does a recipient need to wait for a Schedule K-1 to come in the mail. For large partnership/S corporation returns with numerous investors and Schedules K-1, some automation has become a near necessity to charge competitive fees and deliver returns and Schedules K-1 timely.
Technology is changing and evolving every day, and the impact on partnership/S corporation return reporting has been immense. While those with the technology skills can likely build the software and develop the necessary bridge workpapers, data inputs, etc., tax professionals will need to have a detailed understanding of the rules and complexities so they can assist in building out the software. It is important that advisers have procedures in place well in advance of the 2021 Schedule K-1 season in order to ensure that the automation process and custom-made software are capable of adapting to the necessary changes of Schedules K-2 and K-3.
What if I discover historical shortcomings in my reporting?
Much of the consternation for tax advisers will be related to the changes to the format of the information being provided by these new forms. Information that historically would have been included in Schedule K-1 footnotes will now be provided to the partners or shareholders on Schedules K-3. Although the requirement to provide this information has always been in place, it is likely that in some cases the requirements may not have been fully met. Unfortunately, in most cases the partners or shareholders would never be aware they did not receive a necessary piece of information from the partnership or S corporation, especially in the example of a widely held partnership where the partner may not be intimately involved in, or knowledgeable about, the business's day-to-day details. As discussed below, it is important to quickly identify and correct historical errors.
One likely example of missed information is information related to FDII. A domestic partnership that mainly has operations in the United States may have some DEI that could benefit a direct or indirect corporate partner of the partnership. To the extent this information was not reported previously, the corporate partner may have not maximized its FDII deduction. Corporations are permitted to use flowthrough activity of any export sales or services performed abroad in the computation of their FDII deduction. In the event the partnership has one or more direct partners that are domestic corporations, it is required to provide the partners their share of the partnership's/S corporation's:
- Gross DEI;
- Gross foreign-derived deduction-eligible income (FDDEI);
- Deductions that are properly allocable to the partnership's/S corporation's gross DEI and gross FDDEI; and
- Partnership/S corporation QBAI (qualified business asset investment).
In the case of tiered partnerships, a lower-tier partnership must report the amounts specific to the upper-tier partnership to allow reporting of such information to any partner that is a domestic corporation. As there may be ambiguity in the tiered partnership example, the partnership may not have historically provided this information and might now discover that it has partners that required this information. The new Schedule K-3 presents this information in detail on Part IV and allows reporting conformity across all tax preparers.
To the extent insufficient detail was provided in previous years, the partnership/S corporation may be subject to penalties. For tax year 2020, a failure to provide all the information required would trigger a penalty of $280 per each insufficient Schedule K-1. If the information requirement is intentionally disregarded, each $280 penalty can be increased to $560 or, if greater, 10% of the aggregate amount of items required to be reported.
Given the risk and potential tax benefits to your partners, it is important that any historical errors be identified and corrected as quickly as possible.
Penalty relief for tax year 2021
Recognizing that the adoption of new Schedules K-2 and K-3 will create challenges, the IRS has provided transition relief. For tax years that begin in 2021, certain penalties will not be imposed for incorrect or incomplete reporting on Schedule K-2 or K-3 if the filer establishes to the satisfaction of the IRS that it made a good-faith effort to comply with the new reporting requirements (Notice 2021-39).
For purposes of determining whether a filer has made a good-faith effort to complete Schedules K-2 and K-3, the Service will take account of factors including:
- The extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing information relevant to filing the Schedules K-2 and K-3;
- The extent to which the filer has obtained information from partners, shareholders, or the controlled foreign partnership, or applied reasonable assumptions when information is not obtained; and
- The steps taken by the filer 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.
What do recipients need to think about?
As a tax preparer for a partner or S corporation shareholder, you may be seeing a level of detail that you have not previously seen from your partnership/S corporation's Schedules K-1. Individual taxpayers may be getting a level of detail that helps further clarify additional adjustments needed to compute the foreign tax credit (FTC) position or a breadth of information regarding their indirect ownership in passive foreign investment companies. Information that may have once been buried in white paper detail attached to a Schedule K-1 will now be much clearer and in a standardized format. For corporate partners, the same exact issues may arise, as well as additional items, such as the previously mentioned FDII information.
It is important as a taxpayer not to simply make an assumption that all the partnership/S corporation's facts have changed in 2021 if this information is being presented for the first time. To the extent new or unfamiliar information appears, such as FDII attributes or further detail that may impact FTC utilization, owners of passthrough entities may find it worthwhile to contact the partnership/S corporation representative to ensure that crucial information from prior years is not missing.
Further changes on the horizon
Practitioners obtained insight into the potential direction of several international tax regimes with the Biden administration's recent release of the General Explanations of the Administration's Fiscal Year 2022 Revenue Proposal (Green Book). If these proposed changes become effective for future tax years, the form of Schedules K-2 and K-3 will need to change drastically. Regimes such as GILTI and FTCs would be dramatically different from their current form, as both are proposed to move toward a country-by-country calculation. The recently released Schedules K-2 and K-3 are not designed to report at that level of detail. In addition to those changes, tax regimes such as FDII and base-erosion and anti-abuse tax (BEAT) are proposed to be eliminated. BEAT will potentially be replaced with the Biden administration's proposed regime called "stopping harmful inversions and ending low-tax developments"(SHIELD). SHIELD is based on different inputs than BEAT and would require a complete overhaul of such forms.
Major change in practice
Schedules K-2 and K-3 will be a major change to partnership and S corporation reporting in 2021 and beyond. Many have suggested tailoring 2020 Schedule K-1 white paper detail to conform to the 2021 Schedules K-2 and K-3 in order to avoid issues going forward, but some tax preparers have not been so diligent. Because the process of gathering and reporting Schedule K-1 information is already onerous while operating on tremendously tight timelines, it is crucial to have procedures in place prior to the beginning of the 2021 Schedule K-1 reporting season.
Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or email@example.com.
Contributors are members of or associated with Crowe LLP.