Important Update: New Requirements for Partnerships & S Corporations

Tax Year 2021 Update | Schedules K-2 and K-3 | Rea CPA

On January 18, 2022, the IRS issued important updates to the instructions related to filing the new Schedules K-2 and K-3 for tax year 2021 for partnerships and S corporations. The purpose of the new reporting obligation is to report items of international relevance to the owners of these pass-through entities. The IRS’s new instructions clarified that even if the entity has no foreign income, no foreign taxes paid or accrued, no foreign assets, and no other foreign activities, they may still need to file Schedules K-2 and K-3 if the owners of the entity are eligible to claim a foreign tax credit and need the information to file Form 1116 with their individual income tax returns.

The IRS did provide some penalty relief in Notice 2021-39 for good faith efforts to adopt the new filing requirements, but the limited relief simply is not enough given the fact that they made these changes to the instructions at the beginning of the tax filing season. The extent to which this penalty relief can be relied upon is unknown since it is up to the commissioner of the IRS to determine whether you made a good faith effort to comply with the new requirements.

New IRS Guidance Released

After pressure from the U.S. Senate, and the American Institute of CPAs, the IRS provided some further guidance on additional transition relief on February 16, 2022, for certain domestic partnerships and S corporations preparing the new Schedules K-2 and K-3. The additional transition relief exception is posted in an FAQ on the IRS website. Those eligible for this additional exception will not have to file the new schedules for tax year 2021, but will for tax year 2022.

To qualify for this exception for the 2021 tax year, 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.

This additional reporting requirement from the IRS is complex, and could include more than 20 pages for each Schedule K-2 and K-3 that are required to be filed, including gathering significantly more information about identification of indirect owners. There are penalties associated with the failure to file or failure to report complete information on these schedules. Taxpayers should anticipate additional time and fees related to this additional reporting requirement. 

Your Rea advisor will be in touch regarding updates and the best approach that suits your facts and circumstances, but please feel free to reach out to your advisor if you have any additional questions or concerns.

By Matt Dasta, CPA, Director of Tax Services (Dublin office)