IRS provides exception to filing schedules K-2 and K-3 for certain domestic partnerships and S Corporations

The IRS created the schedules to streamline the reporting of items relating to international taxes by pass-through entities. The schedules are required to be completed by partnerships and S corporations with foreign activities, foreign partners and shareholders, and partners and shareholders that are US entities or individuals claiming foreign tax credits or are otherwise subject to international tax provisions.  

Last year, the IRS initially granted transition relief from IRC Sections 6698, 6721 and 6722 penalties for taxable years that begin in 2021 with respect to new Schedules K-2 and K-3 to Form 1065 and Form 1120-S pursuant to Notice 2021-39.  Under this set of rules, the transition relief would only apply to the extent domestic partnerships or S corps, regarded as K-2 and K-3 filers, make a good faith effort to comply with the Schedules K-2 and K-3 filing requirements (and the Schedule K-3 furnishing requirements) as per the instructions. 

Tax practitioners noted that such an effort would still require the gathering of extensive details regarding partners’ distributive share of relevant items which would ultimately result in increased compliance costs to pass-through entities.

However, the instructions to Schedule K-2 and K-3 released in January, 2022 clarified that the schedules would be required if a partnership has a direct or indirect partner who files Form 1116 or Form 1118 to claim the foreign tax credit, even if the partnership itself had no foreign activities and is not subject to foreign taxes. The IRS further noted that a partnership that does not have, or receive, sufficient information regarding a direct or indirect partner must presume the partner is eligible to claim a foreign tax credit and the partner would have to file a Form 1116 or Form 1118 to claim a credit. Thus, all pass-through entities would be required to complete the schedules unless they have confirmed with all direct and indirect partners that they are not claiming the foreign tax credit and do not require additional information relating to international taxation.

In response to comments from the tax community to this broad definition of K-2 and K-3 filers, the IRS  provided an exception to the Schedule K-2 and K-3 filing requirement for the 2021 tax year for qualifying domestic partnerships and S corporations that had no foreign activities, incurred no foreign taxes, had no direct foreign entities as partners (in the case of a partnership), have not provided information to partners and shareholders for 2020 relating to foreign taxes,  and have no knowledge of partners or shareholders needing such information on items of international relevance for 2021. This exception, as well as other information related to Schedule K-2 and K-3, is posted on the IRS website in the form of FAQs 

Mazars’ insight

The exception provided in the FAQs is a relief to taxpayers with no foreign activities or investors who would have been required to incur significant additional time and costs to prepare the new schedules. However, the exception only applies to 2021, so pass-through entities will need to inquire with their partners and shareholders whether they are claiming the foreign tax credit or otherwise require additional information relevant to international tax to determine whether the entities are subject to the new filing requirements in the future.

The exception does not apply to entities with foreign activities or those with investors who have foreign activities who are most drastically impacted by the new reporting requirements and does not ease the substantial burden of transitioning to the new forms. 

Please contact your Mazars professional for additional information. 

Authors 

Moshe Gruber, Manager 
Timothy Evans, Principal
Juan Fernandez, Manager 

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.