As if the current pass-through entity tax requirements were not complicated enough, the IRS introduced new schedules to the mix. Schedules K-2 and K-3 were created for the reporting of international income, deductions, credits, and other miscellaneous items. In case you are not familiar with the term, “pass-through entities” include partnerships, S corporations. Such entities do not generally pay income taxes directly, but rather “pass-through” taxable income, deductions, and credits to their owners. On January 18, 2022, the IRS issued guidance clarifying the timeline for filing Schedules K-2 and K-3 for the tax year 2021 for partnerships and S corporations. The guidance stated that pass-through entities were required to complete Schedules K-2 and K-3 and provide them to all partners/shareholders for the tax year 2021, even if they had no foreign partners, foreign source income or assets generating such income, or any foreign taxes paid or accrued. This requirement added substantial inconvenience and unnecessary paperwork for many partnerships and S corporations with only U.S. activities.
Significant pushback followed the initial announcement of the new requirements and thankfully, the IRS listened. On February 16, 2022, the IRS provided an additional exception for the tax year 2021. Under the new guidance, U.S. partnerships and S corporations will not be required to file the 2021 Schedules K-2 and K-3 with the IRS if the below requirements are satisfied.
- In the tax year 2021, the domestic partnership or S corporation did not have any direct foreign owners.
- In the tax year 2021, the domestic partnership or S corporation has no foreign activity (i.e., no foreign source income, foreign taxes paid or accrued, or assets that generate, have generated, or may reasonably be expected to generate foreign source income).
- In the tax year 2020, the domestic partnership or S corporation did not provide to its owners and the owners did not request international information that would have been reported on the prior year 2020 Form 1065 Schedules K and K-1, lines 16 or 20c or the 2020 Form 1120S Schedules K and K-1 lines 14 or 17d, including any attachments to the tax return.
- In the tax year 2021, the domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting any information that would be reportable on the Schedules K-2 and K-3.
If a partnership or S corporation qualifies for this exception, it does not need to file Schedules K-2 and K-3 with the IRS or with its partners or shareholders. There is, however, an exception to the exception. If a partner or shareholder notifies the partnership or S corporation that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. This means the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.
It is important for the pass-through entity to evaluate the application of this exception when there is uncertainty and to have conversations with shareholders regarding their international activities, consulting with its tax advisor as necessary. A pass-through entity tax return is considered incomplete if it does not contain all necessary forms, leaving potential exposure for the company upon an IRS audit. It is essential to remember that, as of right now, this exception applies only to 2021 tax returns.
If you have any questions or need further consultation regarding your situation, please reach out to a member of our international tax team. We are here to help. We can be reached at 847.982.0333.
Margaret Lulkiewicz, CPA, MSA, Senior, Tax, works with mid-size enterprises focusing on flow-through taxation within a variety of industries, including, auto dealerships, professional services, real estate, and retail. She has provided accounting and tax services for over five years, including compliance and tax planning. Margaret has been with MichaelSilver since 2018. She received her Master’s Degree in Accounting from Dominican University, River Forest. She is a member of the ICPAS.
Kate Russell, CPA, Manager, has a wealth of knowledge in multiple areas of taxation and has worked primarily with business clients to formulate tax strategies. Since joining MichaelSilver in 2018, she has become a member of the international team working with clients across the world as they enter the U.S. market. Kate received her Bachelor of Science in Business from Minnesota State University, Mankato, with a Major in Accounting. She is a member of the AICPA and sits as a committee member of the International Subcommittee of the ICPAS.