Partnerships and S Corporations: What to Expect from Schedules K-2 and K-3

At a glance

• The main takeaway: Many partnerships and S corporations are required to submit a Schedule K-2 and K-3 when filing Forms 1065, 1120-S and 8865 beginning with the 2021 tax year.
• Impact on your business: In a two-part series, we will discuss new tax forms you may be required to complete and what they mean for you and your business in the 2022 tax filing season for the 2021 tax year.
• Next steps: Aprio’s International Tax Team can guide you through the complexities of the new schedules to determine the impact it may have on your return.

Schedule a consultation with Aprio’s International Tax Team today.

The full story: 

Over the summer, the Internal Revenue Service (IRS) released new Schedules K-2 and K-3, which will now be a required Schedule when submitting Forms 1065, 1120-S and 8865. The new schedules will become effective for tax years beginning in 2021 for the 2022 filing season.

The overall intention of the new schedules is to provide greater clarity, establish a standardized reporting format, deliver expanded guidance for partners and shareholders and allow the IRS to assess a pass-through entity’s compliance more efficiently.

Who must file and what?

• Partnerships must file a Schedule K-2, “Partners’ Distributive Share Items” and a Schedule K-3, “Partner’s Share of Income, Deductions, Credits, etc.” along with Forms 1065 and 8865 to report on any activity of international relevance.
• S corporations must file a Schedule K-2, “Shareholders’ Distributive Share Items” and a Schedule K-3, “Shareholder’s share of Income, Deductions, Credits, etc.” along with Form 1120-S to report on any activity of international relevance.
• Partnerships and S corporations must submit a copy of Schedule K-3 directly to its partners or shareholders.

On February 16, 2022, the IRS published Frequently Asked Questions (FAQ) wherein it announced an exemption from Schedules K-2 and K-3 for certain partnerships and S-corporations. FAQ 15 states that flow-through entities that meet the following criteria will not need to include Schedules K-2 and K-3 with their 2021 returns:

1. There were no foreign partners in the partnership in 2021.
2. The partnership or S-corporation had no foreign activity, no foreign taxes paid and no assets that could give rise to foreign source income in 2021.
3. In 2020, the flow-through entity did not report anything, nor did its partners or shareholders request any information with respect to foreign transactions (Line 16 and Line 20C for Schedule K of Form 1065; Line 14 and 20C for Schedule K of Form 1120-S).
4. The flow-through entity has no knowledge that the partner or shareholder will request such information for 2021.

In the event that a partner or shareholder notifies the entity that it requires the information to be reported on Schedules K-2 and K-3, the entity must provide the information to the partner or shareholder. If the entity has not yet filed its return, it will be required to include Schedules K-2 and K-3 with its return. The FAQ is silent as to what is to be done if the entity has already filed without including Schedules K-2 and K-3.

Good Faith Efforts to Avoid Penalty

Traditionally, failure to file accurate schedules could lead to penalties, however, in Notice 2021-39 the IRS has acknowledged that not every pass-through entity will have a system in place to effectively obtain the detailed information necessary to complete the new schedules. To help ease the pressure for returns filed in 2022, penalties will be waived for Schedules K-2 and K-3 that are filed incorrectly for tax years beginning in 2021, if the partnership or S corporation establishes it made a good faith effort to comply with the new requirements. The IRS will evaluate an entity’s good faith effort to determine if they took the necessary steps to try and obtain the relevant information needed to comply with the Schedules K-2 and K-3 filing requirements.

The bottom line

The creation of Schedules K-2 and K-3 can take a significant amount of time and resources to complete due to the complexity and sheer amount of information that needs to be collected. Entities that may need to include the Schedules should already be working with their tax advisors to prepare the information or document why they qualify for the exemption described in FAQ 15 discussed above. Partners and shareholders, once you receive your schedules, reach out to your tax advisor as early as possible to avoid filing delays. Aprio’s International Tax Team can guide you through the complexities of the new schedules to determine the impact it may have on your return.

Stay tuned for the second part in our series where we will discuss Section 1061 reporting guidance and the impact on pass-through entities.

Schedule a consultation with Aprio’s International Tax Team today.

Related resources

• About Aprio’s International Tax Services