The new Schedules K-2 and K-3 bring sweeping changes to the U.S. international tax reporting landscape for pass-through entities. These new schedules are required for tax years beginning on or after January 1, 2021. The Schedules K-2 and K-3 are filed with the U.S. federal Form 1065 partnership tax return, the Form 1120S S corporation tax return, and the Form 8865 by U.S. partners in controlled foreign partnerships (Filer Categories 1 and 2).
Initially, the filing threshold was supposed to be based on whether the pass-through entity had items of international tax relevance during the tax year. However, the IRS announced some changes to the filing instructions for the U.S. federal Form 1065 Schedules K-2 and K-3 on January 18, 2022. The updated IRS instructions basically require partnerships to presume that their partners could be eligible to claim a foreign tax credit on their respective tax returns if the partnership does not have or receive sufficient information to establish the contrary. Consequently, partnerships generally are required to file the Schedules K-2 and K-3 with the federal Form 1065 partnership tax return even if the partnership does not have any foreign source income, assets producing foreign source income, or foreign tax paid or accrued.
One possible technique would be for the partnership to obtain written statements from each partner that they would not be eligible to claim a foreign tax credit on the partner’s respective tax return. Otherwise, partnerships that only have U.S. source income are still required to report the U.S. source income and deductions on the Schedules K-2 and K-3. This is because conceivably there could be some individual or corporate partner that would need the U.S. source income to be included in their worldwide income for purposes of the denominator in the foreign tax credit limitation calculation impacting the partner’s federal income tax return.
The Form 1120S Schedule K-2 and K-3 instructions indicate that S corporations are basically treated like partnerships for purposes of the foreign tax credit provisions. The IRS has not officially released an update to the Form 1120S Schedule K-2 and K-3 instructions. Although, it is expected cautiously that the same logic would apply for the Form 1065 and 1120S Schedule K-2 and K-3 reporting.
To further compound the difficulty, the IRS has announced that the e-filing for the 2021 Schedules K-2 and K-3 will not be possible until after the original tax filing due date on March 15, 2022 for 2021 federal Forms 1065 and 1120S. The tax return preparation software vendors also need time to integrate the software and IRS e-filing systems which is expected to result in additional e-filing delays. A potential workaround solution is to attach the Schedules K-2 and K-3 as pdf attachments to the tax return e-files so that the tax returns can be e-filed by the original due date. However, some tax return preparation software vendors have announced that e-filing may not possible before 3/15 for pass-through entity tax returns with more than 50 partners or shareholders due to certain page limit constraints for e-file attachments.
For more information regarding the Schedule K-2 and K-3 reporting, please contact Alison Dougherty.