The New Trap - Schedules K-2 and K-3

Last year in June, the IRS issued two new form schedules to accompany pass-through entity returns (Forms 1065 and 1120S) starting in the 2021 tax year - The Schedule K-2 and K-3. The K-2 consists of 11 parts over 19 pages and the K-3, 13 parts over 20 pages. The purpose of these schedules is to help reduce money laundering, better improve international activity reporting and to report foreign activity at the entity level to the individual owners. The IRS also issued draft instructions shortly after issuing the schedules which stated that the forms would be required if the entity had foreign transactions (“Who Must File: The partnership need not complete this schedule if the partnership does not have items of international tax relevance (typically, international activities or foreign partners)”) .

A couple of weeks ago, the IRS issued final instructions and with them a trap. Instead of the trigger for the schedules being at the entity level, the trigger now resides at the individual owner level. Even if the entity did not have foreign transactions, the entity must file these schedules if the owner claims a foreign tax credit (Form 1116) on their personal returns.

As such, every pass-through entity needs to determine if it has items of international tax relevance with respect to its direct and indirect owners. A U.S. entity with no foreign-sourced income, no assets generating foreign-sourced income, no foreign taxes paid or accrued, and no foreign owners may still need to report information on Schedules K-2 and K-3 if an owner is eligible to claim a credit for foreign taxes paid on other sources of foreign income on their own tax return.

The forms are required if the entity lacks positive evidence that each owner is not eligible to claim a foreign tax credit on their return. Put another way, if the entity is unsure if an owner may be claiming a foreign tax credit on their return, these new forms are required.

Penalties for failing to file these forms can be as much as $570 per missing form.

The process of gathering, analyzing, and reporting all of this data that is now required is complex and may consume a substantial amount of time, resources, and significantly increase the cost to complete properly.

Costs for return preparation when these forms are required will double or triple when compared to returns without them.

To avoid penalties and be in compliance, I will be requiring positive evidence from each entity owner that they are not subject to filing Form 1116 as part of their individual returns or I will prepare the extra schedules and charge for them.

There is still a lot unknown and undetermined about these new forms, as they are complex and extensive and may require many filers to be placed on extension.