New International Tax Reporting Required with Partnership and S Corporation Tax Returns

In recent years, the IRS has continued to emphasize U.S. international tax reporting as a high enforcement priority.  U.S. taxpayers with outbound activities in other countries are subject to strict U.S. international tax reporting requirements that require certain disclosures to the IRS.  Substantial penalties apply for noncompliance.  Many of the international tax reporting forms are very technical and require extensive specialized knowledge in international tax to prepare them accurately on behalf of taxpayers.  The IRS campaign to enforce compliance with international tax reporting continues to drive implementation of even more technical requirements.  Beginning with the tax year 2021, partnerships that file the federal Form 1065 partnership tax return will be subject to strict IRS scrutiny with respect to international activities.

On July 8, 2020, the IRS released draft Schedules K-2 and K-3 that partnerships will be required to file with the federal Form 1065 partnership tax returns beginning with the tax year 2021.  The new Schedules K-2 and K-3 each involve 20 pages of disclosures related to cross-border international activities.  Partnerships that engage in outbound activities in a foreign country are subject to the filing requirement.  Partnerships that have inbound foreign partners are subject to the filing requirement.  On July 14, 2020, the IRS released an announcement regarding the new reporting requirement.  At that time, the IRS advised that it also plans to require similar Schedules K-2 and K-3 for S corporations beginning with the 2021 tax year.

The Schedules K-2 and K-3 require reporting of international tax information in nine separate sections of the forms.  Certain information must be disclosed relating to different types of foreign source income by foreign tax credit limitation basket.  Expenses related to foreign source income must be disclosed for purposes of allocation and apportionment of deductions to foreign source income.  Partnerships must report foreign taxes paid or accrued.  It appears that the purpose of reporting foreign source income, deductions, and taxes is to systematically track foreign tax credits.  Information regarding foreign corporations such as Subpart F income, GILTI, and distributions from controlled foreign corporations (CFCs) must be reported.  The partnership is required to report specific information regarding payments of interest and royalty expense in certain hybrid transactions that could give rise to disallowed deductions.  The partnership also has an obligation to report information relevant to C corporation partners for the foreign derived intangible income (FDII) deduction and the base erosion and anti-abuse tax (BEAT).  Extensive reporting is also required to track effectively connected taxable income (ECTI) and passive FDAP income that are subject to foreign partner withholding tax and nonresident withholding tax, respectively, when the partnership has foreign partners.

The main difference between the schedules is that the Schedule K-2 reports the information in the aggregate for the entire partnership while the Schedule K-3 reports each partner’s respective share of the information.  The Schedules K-2 and K-3 are designed to effectively replace the more simplified reporting of foreign source income, deductions, and taxes that are currently reflected on line 16 of the Form 1065, Schedules K and K-1.

Clearly, the new 2021 Form 1065 Schedules K-2 and K-3 will add significant complexity and cost to the preparation of federal partnership tax returns.  Most if not all of the technical disclosures required on the Schedules K-2 and K-3 require specialized technical international tax knowledge to be able to complete the forms accurately.  These new international tax reporting requirements will have a significant impact on the tax compliance process for partnerships and also likely for S corporations beginning with the tax year 2021.  Plan in advance now to upscale capabilities in order to stay ahead of the curve.  It is advisable for businesses that are pass-through entities to communicate with tax advisers early to create a strategy plan to implement processes necessary to collect the information required for the preparation of the Schedules K-2 and K-3.  Templates, tax organizers, checklists, and standardized information request lists will all be essential resources that can help pass-through entities provide the information for the efficient methodical preparation of the Schedules K-2 and K-3.  The Schedule K-2 and K-3 preparation will ultimately require effective communication between the pass-through entity and the tax adviser based on a common understanding of the applicable international tax concepts.

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