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S Corporation and Partnership Tax Filers – You may need to complete additional schedules K-2 & K-3 to report your foreign activities (even if you have none!)

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Effective for tax years beginning in 2021, the IRS will generally require new Schedules K-2 and K-3 for persons filing Forms 1065, 8865, and 1120-S.  Partnerships/LLCs and S corporations are to use Schedule K-2 to report partners’ or shareholders’ “total” distributive share of certain foreign items, whereas Schedule K-3 is designed to provide each specific partner’s or shareholder’s “allocable share” of these foreign items.   If required, each partner/shareholder will actually get a Schedule K-1 AND a Schedule K-3.

Why?

While these schedules are largely focused on international tax items, they are also required to be populated in purely domestic operating situations. This increased reporting provides information around category and source of income to help partners and shareholders correctly calculate foreign tax credits.

In addition to sourcing, the new schedules will provide detailed information to better facilitate the preparation of Form 5471 (Controlled Foreign Corporations), Form 8621 (Passive Foreign Investment Companies), Form 8991 (Base Erosion Payments), and Form 8993 (Foreign-Derived Intangible Income).

What if you don’t have any foreign income or activities?

The IRS clarified that a business with no foreign-source income must still file Part II (foreign tax credit limitation) and Part III (information for preparing Forms 1116 or 1118) on Schedules K-2 and K-3 if their partners have items of international tax relevance.

An exception from filing Part II and Part III, Section 2, on Schedule K-3 may apply, however, for a partnership that:

  • only has US-source income;
  • does not have income or deductions that the partners can source or allocate and apportion; and
  • only has limited partners owning less than 10% of the capital and profits of the partnership at all times during the tax year.

The revised forms’ instruction language makes it very clear that a large number of, if not most, partnerships & S Corporations will be required to file these forms even though the entity does not have any foreign owners, nor any foreign activities.  For example, if the partner claims a credit for foreign taxes paid by the partner (i.e., and this FTC is from an unrelated entity) , the partner may need certain information from your partnership to complete Form 1116.  Also, a partnership that has only domestic partners may still be required to complete Part IX when the partnership makes certain deductible payments to foreign related parties of its domestic partners. The information reported in Part IX will assist any domestic corporate partner in determining the amount of base erosion payments made through the partnership, and in determining if the partners are subject to the Base Erosion and Anti-Abuse Tax.

OBSERVATION:  The foreign tax credit creates the largest number of cases where owners who may have believed they did not need to prepare Schedule K-2 and K-3 will find they have been mistaken.

Failure to file complete and accurate Schedules K-2 and K-3 can trigger various penalties that can depend on the number of partners or shareholders the entity has.

These new schedules are significant (e.g., Schedule K-2 is 19 pages!), especially if there are foreign partners or foreign operations. Schedule K-3 may also include information not previously reported on Schedule K-1 that could lead to additional filing requirements.     We will keep you up to date on the Schedule K-2 and K-3 filing requirements as the IRS provides more guidance or FAQ’s on these new forms.  As you may have surmised, unfortunately, it will also take more time for your preparer to complete your tax return this year, too.

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