The IRS has recently created new forms to standardize the foreign activity reported by partnerships and S corporations
By Fred Chang, International Tax Director, and Yuki Miyajima, International Tax Manager
The Internal Revenue Service (IRS) has introduced a new reporting requirement for the 2021 tax year for any pass-through entities with international activities, including entities with foreign partners. The agency has created two new forms, Schedules K-2 and K-3, to supplement all Schedule K-1 filings. Many of the international items required by Schedules K-2 and K-3 were formerly reported on a partner’s or shareholder’s Schedule K-1 as foreign transactions. However, the introduction of Schedules K-2 and K-3 clarifies and standardizes the reporting of international items required to be reported by the IRS and how they must be documented. While the tax agency has given significant notice that these new requirements are coming, many organizations may still be unsure how to proceed.
These new forms are a landscape shift in reporting standards for international tax-related matters for income, expenses and credits for pass-through entities. In past years, a pass-through tax filer may have addressed its K-1 international disclosure requirements by including the information it deemed was necessary to its partners or shareholders in a K-1 footnote. Oftentimes, this approach could be cumbersome to partners or shareholders — not only due to the non-standardized format of these disclosures, but also from the inconsistent information reported. Schedules K-2 and K-3 seek to address this issue and provide partners and shareholders of pass-through entities with more clarity over their U.S. income tax burden, as well as income or deductions from overseas interests. This enhanced information should also allow the IRS to better verify that partnerships and S corporations are properly meeting their international disclosure requirements, which may reduce the need for follow-up inquiries and examinations from the IRS.
Who Needs to File Schedules K-2 and K-3?
In general, all pass-through entities with items of international tax relevance, including entities with foreign partners and international activities, will be required to use these new forms. Filers of Form 1065, Form 1120-S, and Form 8865 with cross-border activities, foreign partners or partners requiring certain information to claim foreign tax credits, may be required to file Schedules K-2 and K-3.
What Needs to Be Reported on Schedules K-2 and K-3?
Pass-through entities must report items of international tax relevance on Schedules K-2 and K-3, which include:
- Information relevant to foreign tax credit limitation with separate reporting of income and deductions by source and category; this includes information for research and experimentation (R&E) expense, interest expense and foreign-derived intangible income (FDII) deduction apportionment factors.
- Distributions from foreign corporations and/or information related to interests in foreign entities, including Subpart F income and Global Intangible Low-Taxed Income (GILTI) inclusions.
- Information of foreign partner’s share of partnership income and deductions as U.S. source income, foreign source income and/or U.S. effectively connected income.
- Information for passive foreign investment company (PFIC) reporting, base erosion and anti-abuse tax BEAT (Section 59A), and FDII deduction.
What Are the Differences Between the Forms?
Schedule K-2 will report the partners’ total international distributive share of items (international tax-related income, expenses and credits) for a pass-through entity. Meanwhile, Schedule K-3 is provided to each partner or shareholder with their share of international income, deductions, credits, etc.
Will the IRS Penalize Companies for Incomplete Forms?
There will be significant penalties imposed related to the new Schedules K-2 and K-3 for failure to file timely or filing incomplete returns, such as information returns, payee statements and information required under Section 6038. Recognizing the increased complexity in preparing these new forms, the IRS released Notice 2021-39, which provides penalty relief for incomplete or incorrect reporting for taxpayers who can establish that it made a good faith effort to comply with the new reporting requirements.
Note that IR-2022-38, released on February 16, 2022, provides an exemption for eligible partnerships and S corporations from Schedules K-2 and K-3 filing for the 2021 tax year. Generally, this exemption applies to domestic partnerships and S corporations with no foreign activity and no direct foreign partners. However, the IRS clarified on website FAQs updated on April 11, 2022, that entities that do not qualify for the exemption are not required to complete all parts of the schedules but only relevant portions.
Complying with the new schedules can create an additional level of complexity for pass-through entities. It requires solid documentation and experience with international tax standards. That is why companies with international activities should ease their burden and retain the services of the BPM International Tax Services team. This group of seasoned professionals is experienced in the intricacies of foreign tax structures and their impact on American corporations. They are keenly aware of any changes to the U.S. tax code and can help guide organizations of all sizes with their filings.
If you want to learn more about how BPM can help you navigate the complexity of international taxation, and support you with your international tax needs, please contact Fred Chang.
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