Prepare for Schedules K-2 and K-3 Pass-Through Entity Reporting Requirements
New for 2021, pass-through entities may be required to complete Schedules K-2 and K-3 to include items of international tax relevance.
Background
In 2018, the IRS announced plans to revise how pass-through entities report on income, credits, deductions, and other items that come from international sources. Those revisions apply to anyone filing Forms 1065, 8865, and 1120-S. Many companies already report information related to international partnerships on Line 16 and in supplemental footnotes to Schedule K-1. The new Schedule K-2 and K-3 simply replace, supplement, and clarify the prior reporting.
The purpose of these changes, according to the IRS, is, “To provide greater clarity for partners and shareholders on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits.”
The new standardized format assists pass-through entities in providing partners or shareholders with the information necessary to complete their returns with respect to international tax aspects and allows the IRS to verify tax compliance more efficiently.
Items of international tax relevance are very broadly defined and can include reporting foreign tax credit-related information, interests held in foreign entities, foreign partner’s US sourced income or US effectively connected income, and other international tax items.
What This Means for Tax Year 2021
Meeting the new partnership reporting requirements involves completing extensive documentation and collecting voluminous amounts of data. Under the original guidance issued by the IRS, almost all pass-through entities would be required to file schedules K-2 and K-3, which are 19 pages and require documentation from the pass-through entities and foreign owners. That means making sense of the new regulations will be one hurdle, and simply complying with them will be another.
The IRS originally issued penalty relief to anyone that makes a good faith effort to file the new schedules. However, in order to be granted that lenience, a taxpayer must file the Schedule K-2 and K-3 in the first place.
In February, the IRS provided further relief. 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.
How Should You Prepare?
Every business should review if they need to comply with the new Schedule K-2 and K-3 pass-through reporting requirements because while the new schedules relate to international activities, they may apply to businesses with no foreign customers, suppliers, or partners, and create additional filing obligations on your 2021 tax return.
With the complexity surrounding of these new rules and delays with the IRS accepting these schedules for electronically filed returns, a tax return filing extension may be needed to file a complete and accurate return.
Beyond that, we suggest working with a trusted tax advisor to understand how the new pass-through reporting requirements fit into your broader tax strategy. The right planning around these requirements helps lower tax liability, reduce filing stress, and avoid IRS penalties. Put those plans in action sooner rather than later – contact Proseer.
