IRS finalizes international reporting Schedules K-2 and K-3 for pass-throughs, but provides transition relief

In brief

The IRS has released final versions of two new forms that should be added to the tax returns of pass-through entities to report certain international income, deductions, credits, and other miscellaneous items. For tax years beginning in 2021, a partnership must file Schedule K-2 (partners’ total international distributive share items) and Schedule K-3 (partner’s share of international income, deductions, credits, etc.), if the partnership has relevant international tax items. Additionally, S corporations with international tax relevance, as well as certain Form 8865 filers, will have similar Schedules K-2 and K-3 filing obligations for tax years beginning in 2021.

The new schedules are intended to provide more transparency and clarity for the owners of pass-through vehicles regarding how to calculate their US income tax liability from relevant international items. The IRS designed these specific schedules to replace the current reporting for these items (which often occurs on Line 16 and footnotes to K-1s) so that the information provided to owners is delivered in a standard format with an additional level of detail.

Under Notice 2021-39, certain transition penalty relief for tax year 2021 may be granted if the filer makes a good faith effort to comply with the new IRS reporting requirements. Moving forward, applicable filers should start assessing the impact for the next filing season. 

Outlined below is an analysis of key observations from the new Schedules K-2 and K-3 that affect various entities, including hedge funds, private equity funds, real estate funds, and other stakeholders in the asset management industry. 

The takeaway:  Taxpayers should analyze and identify the process and reporting gaps between prior-year requirements and the requirements under new Schedules K-2 and K-3. In order to seek reliance on the transitional relief provided in Notice 2021-39, taxpayers should review the good faith effort requirements and document the efforts taken to update their information-gathering and reporting systems, processes, etc.

PwC video: This video provides an overview of the New Schedules, including the changes in reporting, the information required, managing investor expectation, and what entities can do to prepare for the new requirements. 

Overview of Schedules K-2 and K-3

Taking Form 1065 Schedule K-2 as an example, there are 11 parts in total (Part XII in the final version was reserved for future use), with such parts being further divided into different sections. For example, Part II (Foreign Tax Credit Limitation) includes two sections, and Part III (Other Information for Preparation of Form 1116 or 1118) includes five sections. 

Observation: Although Schedule K-2 includes 19 pages in total, the actual filing package for Schedule K-2 in practice may include fewer or more pages depending on the partnership’s international activities. This is because certain pages might need to be duplicated due to information overflow or mandatory additional statements, while other pages might be left blank due to inapplicability. 

Form 1065 Schedule K-3 contains the same 11 parts discussed above, and also includes Part XIII, which relates to partners’ distributive share of deemed sale items on the transfer of an interest in a partnership that is engaged in a US trade or business . Also, additional tables and worksheets must be attached to Schedules K-2 and K-3 based on the final instructions. Please see the Appendix for a summary table of all parts and sections listed in Schedules K-2 and K-3. 

Schedules K-2 and K-3 are intended to replace, supplement, and clarify for partnerships and their partners, and for S corporations and their shareholders, how to calculate and report their US income tax liabilities when considering potential international-related income, deductions, credits, and other miscellaneous items. As previously noted, the New Schedules require large volumes of data and information that the partnership must gather. 

Observation: Although most of this information already was required to be included with previous Schedules K and K-1 (on line 16 and on additional white paper statements (the ‘K-1 Footnotes’)), in practice, relevant international details might only have been delivered to certain partners upon their request. The lack of consistency in reporting items with international tax relevance may have been difficult for some partners in seeking to properly report international tax items attributable to their partnership interests. 

Furthermore, many international tax rules were altered and expanded by the 2017 tax reform act. That act requires that partnerships provide additional information to certain partners with regard to international tax attributes such as GILTI, BEAT, and FDII. 

On a positive note, Schedules K-2 and K-3 may help to standardize the international tax information for partners. This might be welcomed by upper-tier investment partnerships and others that receive and process large volumes of partnership information, which used to be included in white paper statements. For example Part VII includes information to complete Form 8621, more specifically, information on passive foreign investment companies (PFICs) and related elections.

In a similar context, Schedules K-2 and K-3 also may effectively replace certain filing requirements of partnerships with respect to foreign information reporting. Based on recently released draft Form 8992 instructions, domestic partnerships no longer may be required to file Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI) and a new separate Schedule A due to the introduction of Part VI of Schedule K-2 and Part VI of Schedule K-3.   

Observation: Gathering, analyzing, and reporting all the data required in Schedules K-2 and K-3 creates more complexity in the tax compliance process and will require a substantial amount of filers’ time and resources. Although all parts of the New Schedules include ‘not applicable’ exceptions, such exceptions typically require that the filer knows about demographics for both the direct and indirect partners. If the filer does not have this knowledge, the presumption typically would be that there is not an applicable exception, and the filer must complete the relevant part. Therefore, a detailed analysis and determination of whether certain parts will apply to the filer become important when the filer is gathering information for the New Schedules. In addition, planning and communication regarding the timing of providing Schedule K-3 to the partners is important because the current version of the final instruction requires attaching all applicable international tax forms filed by the partnership to the Schedule K-3.

What’s next?

Due to the large volume of data required in Schedules K-2 and K-3, for tax years beginning in 2021, most filers of Forms 1065, 1120-S, and 8865 may need to rely on Notice 2021-39 to avoid potential penalties associated with incomplete or inaccurate Schedules K-2 and K-3 filings. Note: Filers will not automatically qualify for the penalty relief provided in the notice without a good faith effort to obtain and process all information required by Schedules K-2 and K-3. 

Therefore, for all filers, the first step should be to analyze and identify the gap between their current international-related information reporting procedure and the applicable additional requirements based on Schedules K-2 and K-3. Once filers identify and document the gaps, they should consider discussing the gaps with their international tax advisors and determine whether they need to change their information-gathering and reporting systems, processes, and procedures in order to meet the new filing obligation. Finally, tiered-partnership structures will need to consider potential delay in receiving information from lower-tier partnership investments due to additional K-3 information disclosures and attachments, which include international tax forms that generally have not been prepared until later in the year after Schedule K-1s have been issued. Partnerships should allow sufficient time to process the additional details from lower-tier partnership investments at the upper-tier partnership level. Awareness of, and planning for, potential reporting delays or obstacles are crucial when planning for the upcoming and future year filing seasons.