- The new detailed schedules must be filed by all passthrough entities with items of international tax relevance, including entities with foreign partners and international activities.
- The new schedules will create more clarity for shareholders and partners when it comes to calculating U.S. income tax liability and international-related income and deductions.
- The new schedules should not be as burdensome as skeptics believe once all of your ducks are in a row.
- However, filing correctly requires an in-depth understanding of complex international tax concepts. Don't be a do-it-yourselfer here.
Beginning with tax year 2021, partnerships, S corporations, and filers of Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships (for U.S. persons who are partners in foreign partnerships, or entities electing to be taxed as partnerships), will be required to include the new Schedules K-2, Partners' Distributive Share Items — International, and K-3, Partner's Share of Income, Deductions, Credits, etc. — International, with their returns if they have items of "international tax relevance." More on that definition in just a minute.
At their core, the new schedules and accompanying instructions are designed to help partnerships report certain U.S. international tax information to their partners in a standardized format. This should make it easier for partners to compute and report their corresponding U.S. income tax liability — and make enforcement of cross-border tax compliance easier for the IRS.
Who must file Schedules K-2 and K-3?
The new schedules must be filed by all passthrough entities with items of international tax relevance, including entities with foreign partners and international activities. Essentially, filers of Form 1065, U.S. Return of Partnership Income, Form 1120-S, U.S. Income Tax Return for an S Corporation, and Form 8865 that have cross-border activities, investments, owners, or income may need to file Forms K-2 and K-3 in the upcoming year.
Items of international tax relevance are very broadly defined. For example, the IRS recently published an update clarifying that passthrough entities that have partners or shareholders claiming a foreign tax credit may be required to file the new schedules even if those entities have no foreign-source income or offshore assets. That is because income and deduction sourcing information may be relevant for partners claiming a foreign tax credit.
[Editor's note: In response to feedback from the tax community about the practical difficulties created by this recent clarification, the IRS on Feb. 16 announced transitional relief (IR-2022-38). For 2021, eligible passthrough entities with no foreign activities or foreign partners/shareholders and without knowledge of partner or shareholder need for information on items of international relevance will not have to file the new schedules. See news story.]
What drove the creation of Schedules K-2 and K-3?
Private-equity funds and alternative asset management funds — including a fund of funds, hedge funds, real estate funds, energy funds, and venture capital funds — currently report their international tax information across various forms and schedules. They pass on much of the information to their partners via a hodgepodge of supplemental statements, white paper disclosures, pro forma forms, and/or footnotes attached to or provided with Schedules K-1, Partner's Share of Income, Deductions, Credits, etc.
As many of you know, the disparate statements and disclosures have no standardized format, so the partners receiving the statements and disclosures can find it hard to translate the information across various partnership investments when reporting the required information on the partner tax returns.
The new Schedules K-2 and K-3 provide partnerships with a standardized format for reporting U.S. international tax information to their partners, including withholding and sourcing details for foreign partners and U.S. international inclusions, or foreign attributes relevant for domestic partners.
How Schedules K-2 and K-3 differ from Schedule K-1
Schedules K-2 and K-3 will replace, supplement, and clarify the former line 16, "Foreign transactions," of Schedule K, partners' distributive share items (Form 1065), and line 16, "Foreign transactions," of Schedule K-1 (Form 1065).
Schedules K-2 and K-3 also replace, supplement, and clarify reporting of certain amounts that were formerly reported on Form 1065, Schedule K, line 20c, "Other items and amounts," and Schedule K-1, Part III, line 20, "Other information."
In a nutshell, the new forms will create more clarity for shareholders and partners when it comes to calculating their U.S. income tax liability or when considering potential international-related deductions, credits, and miscellaneous items. Much of the information to be included in Forms K-2 and K-3 was already required in Schedules K-1 via a white paper attachment. The new schedules require filers to provide information in a standardized format and with an additional level of detail.
Clarifying 'items of international tax relevance'
Note: Schedules K-2 and K-3 only apply to filers of Forms 1065, 1120-S, and 8865 that have an item of international tax relevance. While there is no concise definition of what "an item of international tax relevance" is, there is a reference to "the international tax provisions of the Internal Revenue Code" in the form instructions. Examples of items of international relevance that must now be reported on Schedules K-2 and K-3 (as opposed to on Schedules K and K-1) include:
- Foreign tax credit–related information including the sourcing and basketing of income and deductions, including information related to items such as R&E expenses and interest expense.
- Interests in foreign entities or distributions from foreign corporations.
- Foreign partner's U.S.-source income and/or U.S. effectively connected income, including the distributive share of deemed sale items on the transfer of a partnership interest.
- Information related to:
- Investments in foreign entities, e.g., passive foreign investment companies.
- Interests in controlled foreign corporations, global intangible low-taxed income (GILTI), and Subpart F income inclusions.
- Foreign-derived intangible income.
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. Note that even partnerships with strictly domestic income and assets may have to complete this section of the Schedules K-2 and K-3 if they have partners that are claiming a foreign tax credit.
The new schedules include comprehensive reporting of items related to international tax provisions within the IRC. The length of the schedules is a quick reference to the volume of information that can be required to be reported:
Schedule K-2 (Form 1065) is 19 pages and summarizes information relevant to the partnership or S corporation.
Schedule K-3 (Form 1065) is 20 pages and summarizes information relevant to each partner. A separate Schedule K-3 must be issued to each partner, like a Schedule K-1 is. The forms may also require additional statements to be attached.
Treatment of undocumented partners
One thing seems to have caught many partnerships off guard. Even if they have no cross-border investments or assets, they are still required to file Schedules K-2 and/or K-3 if they have foreign partners. Undocumented partners are presumed to be foreign. So, it will be important for partnerships to verify that their partners are documented via a Form W-8 or W-9.
Considerations for partnerships, fund managers, and S corporations
The new schedules will add a significant new reporting requirement for partnerships and S corporations. The forms are extensive and, thus, require an in-depth understanding of complex international tax concepts. Among other items, the forms require the filer to understand sourcing rules, foreign-derived intangible income (FDII) rules, dual-consolidated-loss rules, Sec. 267A, and the Subpart F and GILTI rules among others.
Private-equity and alternative asset management funds that have international activities also face a unique challenge with this new reporting requirement. The additional detail required in the new schedules may create an increased tax-compliance burden for funds, investor-relations issues, and timing issues related to delivering Schedules K-1, K-2, and K-3.
If you manage a fund, you may want to revise your timeline and deadlines associated with providing investor tax packages that include these schedules. If you manage a partnership, you may want to separate the delivery of Schedules K-1 from the new Schedules K-2 and K-3.
Note: The IRS announced penalty relief for the 2021 tax year for partnerships, S corporations, and other taxpayers who make a good-faith effort to complete the new forms on time — but who fall short on the new requirements (see Notice 2021-39). Despite the grace period, partnerships and S corporations will want to make plans to complete the forms properly from the outset.
Impact on partners and shareholders
Schedules K-2 and K-3 will provide welcome relief to partners, S corporation shareholders, and their advisers, who often had to interpret a variety of white paper statements. The new standardized format that provides information on items such as the foreign tax credit or passive foreign investment companies (PFICs) should alleviate some of the compliance burden for those taxpayers. This will be especially helpful around the tax deadlines when investors that hold interests in several passthrough entities have a very short window to prepare their returns.
Partners and S corporation shareholders will want to compare the Schedules K-3 they receive this year to the Schedules K-1 they received in the prior year for new or unexpected information. If there is new information, such as indirect ownership of foreign entities that the owners of those passthrough entities were previously unaware of, then it may be prudent to confirm that no crucial information was omitted or lost in the white paper detail in prior years.
Partnerships and S corporations, as well as filers of Form 8865, should prepare for the upcoming filing requirement by ensuring their partners are properly documented with a Form W-8 or W-9, by reviewing their 2021 transactions, and by determining whether the filing requirement applies. While the new schedules are a compliance burden for passthrough entities, they will aid passthrough entity owners and IRS enforcement efforts with respect to international transactions. In the long run, that's good for everyone.
— John Samtoy, CPA, M.S., is a partner in the Irvine, Calif., office of HCVT, where he specializes in international tax consulting and compliance services. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.