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Schedule K-2 and K-3 Reporting

Schedules K‐2 (Partners’ Distributive Share Items – International) and K‐3 (Partner’s Share of Income, Deductions, Credits, etc. – International) are new Service‐issued forms first required for taxable year 2021. Schedules K‐2 and K‐3 are intended as a “formalization” of existing reporting requirements that originally were done through less focused/clear methods (i.e., white paper explanations). However, the forms themselves create significant new disclosure requirements for covered entities – and could also create retroactive compliance concerns for recipient stakeholders.

Schedules K‐2 and K‐3 are required to be filed by taxpayers filing Form 1065, Form 1120‐S, and Form 8865 (i.e., partnerships, S corporations, and taxpayers holding specified interests in foreign partnerships), which have items of “international tax relevance.” “International tax relevance” is not specifically defined for reporting purposes; Schedule K‐2 instructions reference “international activities” and foreign partners (with “international activity” not thereafter mentioned in the instructions). However, Service guidance indicates an all‐inclusive scope for the “international tax relevance” and “international activities” standards; as an example, foreign partnerships can have a filing requirement for partners with foreign tax credits, even if the partnership itself undertakes no foreign activities or earns foreign‐sourced income (based on the partner’s need for the information in computing their foreign tax credit limitation). See here, Q11. Assorted penalties – under Secs. 6698, 6699, 6721, 6722, and 6038 – are assessable if failures to accurately file occur (subject to Notice 2021-39 guidance below).

Assorted international tax items are reportable on Schedules K-2 and K-3 – including interests in foreign entities, foreign tax credit limitations (and other information required for stakeholders to complete foreign tax credit forms), foreign-derived intangible income deduction information, GILTI/Subpart F inclusions, and information on character/source of entity earnings. While this information was previously required to be disclosed, many recipients were unaware of the extent of entity holdings under prior reporting options. Some (and potentially many) stakeholders may discover foreign information reportable at the stakeholder level for the first time – with resultant needs to amend prior year filings.

For tax year 2021, filers of Schedules K‐2 and K‐3 are eligible for penalty relief for tax year 2021 filings which are incorrect or incomplete if a “good faith effort” to comply is established. Notice 2021‐39. A Schedule K‐2/K‐3 filer that does not establish that it made a good faith effort to comply with the new requirements will not be eligible for penalty relief. Or purposes of determining whether a Schedule K‐2/K‐3 filer makes a good faith effort to complete Schedules K‐2 and K‐3, the IRS will take into account the extent to which a Schedule K‐2/K‐3 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 and the extent to which a Schedule K‐2/K‐3 filer has obtained information from partners, shareholders, or the CFP, or applied reasonable assumptions when information is not obtained.

 

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