UPDATE: As reported last week, the IRS provided preparers with additional immediate relief from the new reporting requirements for pass-through entities with no foreign activity, and domestic partners or shareholders who have not notified the pass-through entity they need the information contained on Schedule K-3 to file their return.

The updated guidance, released Feb. 16, explains that, for the 2021 tax year, the new Schedules K-2 and K-3 for partnerships and S corporations are only required when needed to report foreign activities at the partner or shareholder level.

The IRS made its first efforts at providing relief by issuing Notice 2021-39. The notice made transitional penalty relief available to partnerships that make a good-faith effort to comply with the new reporting requirement by making changes to their systems, processes, and procedures for collecting and processing the relevant information. The notice also discusses the possible penalties for failing to include the necessary information in an entity-level return.

The Feb. 16 guidance was included in a set of answers to frequently asked questions (FAQs) issued by the IRS in response to preparer concerns about changes made to the instructions for the Schedules K-2 and K-3 that were posted on the IRS website Jan. 18.

The January revised instructions contained an additional paragraph that describes a domestic entity with no foreign source income or assets. The paragraph notes that if one of the partners plans to or is required to report foreign tax credits on Form 1116, Foreign Tax Credit, the partnership must prepare Schedules K-2 and K-3. S corporations have the same requirement.

The Feb. 16 FAQs provide an additional exception to the filing requirements for partnerships and S corporations that meet the following criteria:

• The direct partners in the domestic partnership are neither a foreign entity nor foreign individuals
• The domestic partnership or S corporation has no foreign activity
• 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 information regarding any foreign transactions
• The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021

Schedule K-2 and K-3 background information

The IRS issued the new Schedules K-2 and K-3 for the 2021 tax year to accompany Forms 1065, U.S. Return of Partnership Income, 1120-S, U.S. Income Tax Return for an S Corporation, and 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. The new forms revised Boxes 16, 14 and 15 of the respective Schedules K-1 by taking a deeper dive into items of international relevance. The IRS’s initial instructions for the new schedules said they were only to be used by entities with international transactions to report.

The Jan. 18 post revised the original forms’ instructions, highlighting the need to file the forms and establishing the link between a partnership’s Schedules K-2 and K-3, and an individual partner’s Form 1116 calculations. Based on those instructions, knowledge that a partner must file Form 1116 drives the partnership’s need to file Schedules K-2 or K-3. As a result, preparers need to make direct inquiries of partners who may not be clients to collect the necessary information and potentially file the 19-page Schedules K-2 and K-3.

Following up on the issues

NATP received feedback from members asking whether the IRS has the statutory authority to request this information. Much of it has focused on the statement in the instructions, “Except as otherwise required by statute, regulations, or other IRS guidance, a partnership is not required to obtain information from its direct or indirect partners to determine if it needs to file each of these parts.”
The answer to question six of the Feb. 16 FAQs states the IRS relies on provisions of the Internal Revenue Code and regulations thereunder – notably Regulation Section 1.6031(a)-1(a)(1) and (2). This regulation merely restates the need for a partnership to file a partnership return “on the form prescribed for the partnership return”.

The information in this post is current as of Feb. 23, 2022.