Who Must File Schedules K-2 and K-3?

New partnership and S corporation taxpayer forms create havoc and confusion

In 2021, the Internal Revenue Service (IRS) issued new schedules K-2 and K-3 for 2021 partnership and S corporation tax returns. The IRS indicated that these new schedules were to be used to provide for more accuracy in international reporting. With this background, the tax community believed these schedules would be limited to entities that were conducting business outside the United States.

However, on January 18, 2022, the IRS updated the instructions for Form 1065, “U.S. Return of Partnership Income,” Form 1120-S, “U.S. Income Tax Return for an S Corporation,” and Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships,” the IRS instructions indicated that entities with no foreign activities or equity holders might still need to complete portions of schedules K-2 and K-3 if a partner or shareholder claims a foreign tax credit and needs information from the entity to complete Form 1116, “Foreign Tax Credit.”

These instructions and further guidance in the IRS’s Frequently Asked Questions set off concerns within the taxpayer community, as the IRS indicated that many or most partnerships would be required to complete these cumbersome filings. The IRS was also very slow to to finalize draft forms and issue schemas, which are used by the tax return software vendors to allow for e-filing.

These actions sent shockwaves as it appeared likely that many partnership and S corporation tax returns would need to be extended until the software could accommodate the schedules K-2 and K-3. The filings also seemed to be overreaching on the taxpayer to prepare forms that are very detailed and cumbersome and may not apply to most of these entities.

The American Institute of Certified Public Accountants (AICPA) and the tax community reacted swiftly and a representative from the IRS spoke at the Senate Finance Committee hearing, indicating

“Although we do appreciate the recent IRS statement regarding transition relief, given the already unprecedented processing backlogs, the AICPA has deep concerns that implementing these new requirements will ultimately exacerbate the challenges everyone in the tax administration community already is facing,” said Jan Lewis, chair of the AICPA Tax Executive Committee. At the hearing, Lewis said the January 18 updates, when combined with an inability for preparers to e-file the schedules until later in the filing season, created confusion and uncertainty for many taxpayers and advisers. Thus, the AICPA is recommending that the agency delay implementation until 2023 at the earliest,” she said.

The IRS did react to the concerns and issued a new filing exception for 2021 tax returns, in its FAQ 15.

Summary of IRS FAQ 15

Is the IRS providing any additional exceptions for tax year 2021?

The IRS is providing an additional exception for tax year 2021 to filing the Schedules K-2 and K-3 for certain domestic partnerships and S corporations. To qualify for this exception, the following must be met:

• In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts.
• In tax year 2021, the domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably expected to generate foreign source income (see section 1.861-9(g)(3)).
• In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders nor did the partners or shareholders request the information regarding (on the form or attachments thereto):
  • Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
  • Line 20c, Form 1065, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (line 17d for Form 1120-S).
• The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.

If a partnership or S corporation qualifies for this exception, the domestic partnership or S corporation does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. However, if the partnership or S corporation is subsequently notified by a partner or shareholder that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.

While this exception will assist taxpayers and tax return preparers for the 2021 tax filing season, managers and owners of partnerships, LLCs, and S corporations should carefully review the requirements and exceptions.

Keiter will continue to monitor these requirements and work with AICPA and other organizations to seek additional relief and limitations on these reporting requirements for entities that do not have international operations.

Questions on your specific entity taxation matters? Contact your Keiter Opportunity Advisor.