Tom Talks Taxes - February 6, 2022
Strategies for dealing with Schedule K-2 and K-3 reporting
Starting with 2021 tax returns, pass-through entities have to file Schedules K-2 (at the entity level) and K-3 (with the Schedule K-1) to report international activities. Until recently, it was believed this new, complex reporting requirement was limited to pass-through entities with international tax attributes.
Over the last few days, this late addition to the Schedule K-2 and K-3 instructions for partnerships on the IRS website has caused an uproar:
A similar provision was added to the Form 1120S instructions.
A plain reading of the above indicates that a partnership or S corporation with absolutely zero foreign activities may still need to file Schedules K-2 and K-3 if any of the owners will file Form 1116, Foreign Tax Credit, as some of the entity’s data may impact the calculation of the foreign tax credit limitation on the owner’s tax return. This could pull millions of unsuspecting entities into a reporting requirement.
The penalties for non-compliance could include the monthly §6698 and §6699 penalties (which apply to both late filing and returns that do not show correct information), §6722 for failure to furnish correct payee statements, and §6721 for failure to file correct information returns.
This seems like an overly burdensome requirement to quietly clarify in the middle of filing season, especially since some of these returns have already been filed prior to this revised instruction. To make matters worse, Schedules K-2 and K-3 aren’t available for e-file yet: the partnership version is slated for mid-March and the S corporation version sometime this summer.
First things first: don’t panic! Let’s discuss what to do about it.
The first possibility is that the IRS walks back this broadening of the filing requirement either in general or for tax year 2021. (Remember the “everyone has to file Form 3115” repair regulations panic?) We will have to see what happens with this.
Let’s assume the IRS maintains the instruction; if so, according to Notice 2021-39, “unless the Schedule K-2/K-3 filer has knowledge to the contrary, it must file or complete certain parts assuming that the information would be relevant to the partner or shareholder.”
Thus, if the entity return filer “has knowledge” that each of the owners won’t be filing Form 1116 (or one of the other more uncommon international forms), then there generally won’t be a Schedule K-2 and K-3 filing requirement for the entity. We will focus in this article on Form 1116 since that form is relatively common.
A taxpayer will not file Form 1116 in these three situations:
The taxpayer has no foreign taxes paid or accrued during tax year 2021, and no foreign tax credit carryover to tax year 2021,
The taxpayer has less than $300 ($600 joint) in foreign taxes paid and elects to credit the entire amount without Form 1116 using the §904(j) election, or
The taxpayer elects to deduct foreign taxes paid on Schedule A (which are not subject to the $10,000 state and local tax deduction cap).
For individuals with foreign taxes paid equalling $300 ($600 joint) or less, the election usually leads to a larger credit since the foreign tax credit limitations do not apply. The only caveat is that the taxes paid must be reported on a third-party information return to be eligible for the election.
The deduction of foreign taxes paid normally leads to less tax reduction than the foreign tax credit; however, if the filing of the Schedules K-2 and K-3 leads to a significant additional compliance cost, or lack of filing creates risk of penalties, then the deduction may make sense in lieu of the credit.
For closely-held businesses, where you do both the entity return and the owner’s returns, you’ll already have this information, and you can work with the owners to potentially bypass the Schedule K-2 and K-3 requirement.
Here is an example of this on the IRS’s addition to the Schedule K-2 and K-3 instructions:
U.S. citizen A and U.S. citizen B own equal interests in domestic partnership. In Year 1, domestic partnership has no foreign source income and no assets that generate foreign source income. Domestic partnership does not pay or accrue foreign taxes. In Year 1, U.S. citizen A pays $100 of foreign income taxes on passive category income which was reported to U.S. citizen A on a qualified payee statement. U.S. citizen A does not pay or accrue any other foreign taxes and has no other foreign source income. U.S. citizen B does not pay or accrue foreign income taxes. In Year 1, because U.S. citizen B paid no foreign taxes for which it can claim a foreign tax credit and U.S. citizen A qualifies for the exemption from completing Form 1116 to claim a foreign tax credit and such information was provided to domestic partnership by both U.S. citizen A and U.S. citizen B, domestic partnership need not complete Schedules K-2 and K-3, Part I, box 1, box 2, box 3, box 4, box 5, and box 10, Parts II or III.
Here’s another example. Marta and Paul are married in tax year 2021 and file a joint tax return in a non-community property state. Marta is a 100% owner of a S corporation with no foreign activities; Paul is the sole owner of a brokerage account holding various mutual fund investments. Since Marta and Paul historically pay less than $600 in foreign tax, they simply credit the entire amount and do not file Form 1116. Because of this, Marta files her 2021 Form 1120S without Schedules K-2 or K-3.
Paul receives his brokerage Form 1099-DIV and it shows $645 in foreign tax paid.
They have three options:
Amend the S corporation return to include Schedules K-2 and K-3,
Elect to deduct the foreign taxes paid on Schedule A, or
File separate tax returns since Marta does not own the brokerage account.
What if you do not prepare the tax returns of all of the partners or shareholders? You have two options:
Prepare Schedules K-2 and K-3, or
Attempt to collect information on each owner as to whether or not they file Form 1116 in order to avoid the requirement, preferably in writing.
Here is an example of a question you can ask to elicit the information you need:
In order to properly prepare the 2021 [partnership/S corporation] return for [insert entity name], and avoid potential penalties, we need to know if you will file or intend to file Form 1116, Foreign Tax Credit, with your 2021 Form 1040. Please initial next to the statement that applies and return this form to our office. Thank you for your assistance!
You will file or anticipate that you will file Form 1116 on your 2021 Form 1040 return.
You did not pay or accrue foreign taxes during tax year 2021, and have no foreign tax credit carryover to tax year 2021, so you will not file Form 1116 with your 2021 Form 1040 return.
You paid or accrued foreign taxes during tax year 2021, but the total is $300 or less ($600 or less joint), and you plan to take a foreign tax credit on your 2021 Form 1040 without filing Form 1116.
You paid foreign taxes during tax year 2021, but will elect to deduct them on your 2021 Schedule A and will not file Form 1116 on your 2021 Form 1040 return.
I prefer a question that is more detailed as it educates taxpayers who self-prepare their tax return while generally causing those with a tax professional to forward it to that professional for a response, ensuring more accurate responses. You may choose to get the information in a less detailed way, or have the taxpayer certify it by signing the statement. There are many ways to meet the knowledge requirement.
In conclusion: do your best with the resources and information you have. The IRS offered transition penalty relief in Notice 2021-39:
During this transition period, a partnership required to file Form 1065, an S corporation required to file Form 1120-S, or a U.S. partner required to file Form 8865 (a “Schedule K-2/K-3 filer”) will not be subject to the relevant penalties described in section 2 for any incorrect or incomplete reporting on the Schedules K-2 and K-3 if the filer establishes to the satisfaction of the Commissioner that it made a good faith effort to comply with the Schedules K-2 and K-3 filing requirements (and the Schedule K-3 furnishing requirements) per the instructions.
A closing hat tip to Robert Gambardella, CPA from #TaxTwitter for the idea to deduct foreign taxes as an option.
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