Will Your Business Tax Return Include New Schedules K-2/K-3?
Starting with taxable years beginning in 2021, Schedules K-2 and K-3 are new schedules to accompany filing Forms 1065, 1120-S, and 8865 (together, “pass-through entities”). Schedule K-2 is an extension of Schedule K and offers a standardized format to report items of international tax relevance from the operation of the pass-through entity. Schedule K-3 is an extension of Schedule K-1 and is generally used to report to owners their share of the items reported on Schedule K-2. These new schedules will also equip the IRS with another tool to verify compliance of taxpayers doing business through pass-through entities.
The new Schedules K-2 and K-3 are extensive. For example, the Form 1065 Schedule K-2 (replacing Forms 1065 Schedule K, Line 16) is 19 pages with 12 parts, while Schedule K-3 (replacing Forms 1065 Schedule K-1, Line 16) is 20 pages with 13 parts. Tax professionals must have a detailed understanding of the pass-through entity’s facts and circumstances to determine which parts of the Schedules K-2/K-3 must be completed and attached with their client’s tax return.
Who Must File?
At first glance of the IRS instructions, it may appear that only pass-through entities with international activities or foreign owners need worry about these new schedules. On page 1 of the IRS instructions for Form 1065 Schedules K-2 and K-3 (released on August 25, 2021), the first sentence under the section Who Must File states: “The partnership need not complete this schedule if the partnership does not have items of international tax relevance (typically, international activities or foreign partners).” Based on the parenthetical of this general instruction, a person preparing a Form 1065 for a domestic partnership with no international activities or foreign partners could conclude that these new Schedules K-2 and K-3 are not applicable. However, the key phrase – “items of international tax relevance” – is much broader in scope than its misleading parenthetical (“typically, international activities or foreign partners”).
One must read through the detailed instructions of each of the 12 parts of Form K-2 and K-3 to determine whether a pass-through entity has such items of international tax relevance to be reported in one or more parts of the 12 parts. Perhaps recognizing the potential confusion of its general instructions, on January 18, 2022, the IRS released changes to the Form K-2 and K-3 instructions. The first change relates to the Who Must File section, with the addition of the following note: “A partnership [S corporation] with no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3.”
For purposes of Schedules K-2/ K-3 reporting, when is a pass-through entity considered to have items of international tax relevance?
The answer depends as much on the composition of the pass-through entity’s direct and indirect owners as on the activities and assets of the business entity itself. An indirect partner includes a partner that owns the partnership interest through another pass-through entity, such as a partnership, S corporation, or a trust. While it should be obvious whether the pass-through entity itself has international activities or foreign assets, it may be practically impossible for it to ascertain the relevant details of all its direct and indirect owners. For instance, a partnership within a tiered partnership structure may not know whether one of the upper tier partnerships has a partner that is a U.S. C-corporation claiming a FDII deduction or in need of determining if it is subject to the section 59A Base Erosion and Anti-Abuse Tax (BEAT). An S corporation may not know whether one of its direct individual owners will be claiming a direct foreign tax credit (or an indirect foreign tax credit by way of a section 962 election) related to investments held outside of this S corporation. A partnership may not know whether one of the upper tier partnerships has a partner that is a foreign corporation or a foreign individual. In the absence of sufficient information or notice regarding its direct and indirect owners, the IRS requires a partnership or S corporation to make certain presumptions that the information is needed by these owners.
Whether a Pass-Through Entity Has Items of International Tax Relevance Based on the Composition of its Direct and Indirect Owners
Whether a partnership must complete Parts II-IV, IX, X, and/or XIII of Schedules K-2 and K-3 generally depends on the composition of the partnership’s direct and indirect partners. The IRS had these Parts of the Schedules K-2 and K-3 in mind when it released the additional note to the Who Must File section of the instructions on January 18, 2022: “A partnership [S corporation] with no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3.”
Part II (“Foreign Tax Credit Limitation”) and Part III (“Other Information for Preparation of Form 1116 or 1118”) of Schedules K-2 and K-3 involve information needed by an individual or corporate owner for purposes of claiming a foreign tax credit on Form 1116 or Form 1118. Unless the pass-through entity has sufficient information or notice that all of its direct and indirect owners are not eligible to claim a foreign tax credit, the pass-through entity must presume that one or more such owners will be filing a Form 1116 or Form 1118. Under this presumption, the pass-through entity must complete Parts II and III of Schedules K-2 and K-3. This is required regardless of whether the pass-through entity pays or accrues foreign taxes because the other information provided in Parts II and III is relevant in determining the owner’s foreign tax credit.
The changes to the instructions released by the IRS on January 18, 2022, clarify when a partnership may know that all its direct and indirect partners are not eligible to claim a foreign tax credit:
- The partnership is not required to complete Part II if the partnership has only U.S. source income and none of the partnership’s income or deductions must be sourced or allocated and apportioned by the partner, and the partnership knows that its only partners are less-than-10% limited partners.
- The partnership is not required to complete Part III, Section 2, if it knows that its only partners are less-than-10% limited partners.
The changes to the instructions for S corporations gives an example of the very limited circumstance that would exempt an S corporation from completing parts Schedules K-2 and K-3
Example. U.S. citizen A and U.S. citizen B own equal interests in S corporation. In Year 1, S corporation has no foreign source income and no assets that generate foreign source income. S corporation 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 the S corporation by both U.S. citizen A and U.S. citizen B, S corporation 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.
With these instructions and examples to consider, the following discussion highlights the remaining sections of Schedules K-2 and K-3 that may be necessary, even when a pass-through entity has no foreign activity of its own. Only the parts of Schedules K-2 and K-3 from Form 1065 are discussed below. Consider similar applications to S corporations.
Part IV (“Information on Partner’s Section 250 Deduction with Respect to Foreign-Derived Intangible Income”) of Schedules K-2 and K-3 involves the information needed by a direct or indirect partner that is a U.S. C-corporation claiming a section 250 Foreign-Derived Intangible Income (FDII) deduction on Form 8993. A partnership with direct or indirect domestic C-corporate partners must complete this part, even if the partnership does not have foreign-derived income. A partnership that does not have or receive sufficient information or notice regarding a partner must presume the partner is a domestic corporate partner or a partnership that has a direct or indirect domestic corporate partner. Even if a partnership has no foreign activities, and therefore has no foreign-derived deduction eligible income (as reported in Section 2 of Part IV), the partnership must still report the information required by Sections 1 and 3 of Part IV so that any domestic corporate partner can correctly determine its section 250 deduction. For example, a domestic corporate partner would still need information about the partnership’s qualified business asset investment (QBAI) in such a case to determine its deemed tangible income return and deemed intangible income.
Part IX (“Partner’s Information for Base Erosion and Anti-Abuse Tax”) of Schedules K-2/K-3 involves the information needed by a direct or indirect partner that is a domestic corporation to determine whether it is subject to the Base Erosion and Anti-Abuse Tax (BEAT), and to determine its amount of BEAT (if any). The BEAT is generally levied on certain large corporations that have deductions and certain other items paid or accrued to foreign related parties (a base erosion payment). Regardless of whether the partnership has base erosion payments, it must complete Part IX to report gross receipts and deductions included in the base erosion percentage calculations to allow a corporate partner to determine whether it’s subject to BEAT. That is, partnerships are not subject to BEAT, but certain corporate partners of a partnership may be subject to BEAT and each corporate partner needs information from the partnership to make this determination. To complete Part IX, the partnership is expected to collaborate with its partners to identify the foreign related parties (if any) of each direct and indirect partner. Part IX of Schedule K-3 is not required to be completed for the following partners: “small partners” (as defined in the instructions), individuals, and S-corporations.
Part X (“Foreign Partners’ Character and Source of Income and Deductions”) of Schedules K-2/K-3 involves the information needed by foreign partners to figure and report their U.S. tax liability on Forms 1040-NR and 1120-F. A partnership may rely on IRS Forms W-8 and W-9 from its partners to determine whether it has a foreign partner. If a partner is a flow-through entity, such partner, or its authorized representative, may notify the partnership as to whether there is a foreign person with a U.S. income tax reporting obligation with respect to a partnership item. A partnership that does not have or receive sufficient information or notice regarding a partner should presume the partner is foreign or that a foreign person has a U.S. income tax reporting obligation with respect to a partnership item and complete the Schedules K-2 and K-3, Part X accordingly.
Part XIII (“Foreign Partner’s Distributive Share of Deemed Sale Items on Transfer of Partnership Interest”) of Schedule K-3 is used by a foreign partner to determine the gain or loss to be reported on its U.S. return from the transfer of an interest in a partnership. Part XIII of Schedule K-3 is required for a partnership that is directly or indirectly engaged in a U.S. trade or business and had a foreign partner if either: the foreign partner transferred an interest in the partnership, or the partnership directly or indirectly transferred an interest in a partnership that engaged in a U.S. trade or business. A separate Part XIII is required for each class of interest transferred. Part XIII of Schedule K-3 can be complicated in a tiered partnership structure with one or more foreign partners.
Whether a Partnership Has Items of International Tax Relevance Based on Its Direct or Indirect Ownership of a Foreign Entity
Parts V through VIII of Schedules K-2 and K-3 generally relate to partnerships that directly or indirectly hold ownership interests in one or more foreign entities. As it is typically more apparent to a partnership whether it must complete one or more of these Parts, a detailed discussion of each is beyond the scope of this article.
Part V (“Distributions from Foreign Corporations to Partnership”) is required if the partnership received a distribution from a foreign corporation.
Part VI (“Information on Partner’s Section 951(a)(1) and Section 951A Inclusions”) is used by certain individual or corporate partners to report Subpart F or GILTI inclusions. A partnership must complete Part VI with respect to a controlled foreign corporation (CFC) if the partnership owns stock of the CFC, unless the partnership owns such CFC stock solely by reason of the downward attribution constructive ownership rules under section 958(b).
Part VII (“Information to Complete Form 8621”) is generally required for any partnership that directly or indirectly owns a passive foreign investment corporation (PFIC).
Part VIII (“Partner’s Interest in Foreign Corporation Income (Section 960)”) is used by certain partners to figure a deemed paid foreign tax credit on Form 1118. The partnership must complete a separate Schedule K-2, Part VIII, for each CFC with respect to which it has a direct or indirect interest, unless the partnership does not have a direct or indirect partner that is a domestic corporation that is a U.S. shareholder or that is eligible to make a section 962 election to claim a deemed paid foreign tax credit with respect to such CFC. An indirect interest is one that the partnership owns through other pass-through entities. Indirect partners are partners who own the partnership through a foreign corporation or through a pass-through entity.
Other – Covered Partnerships and Items of International Tax Relevance
Part XI of Schedules K-2 and K-3 (“Section 871(m) Covered Partnerships”) must be completed if the partnership is a publicly traded partnership (PTP) that is a covered partnership or directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership, regardless of whether the partners are domestic or foreign.
Forms Schedule K-2 and K-3 require additional disclosures for 2021 tax returns for partnerships, S corporations and “U.S. Persons with Respect to Certain Foreign Partnerships” (Form 8865 filers). The release of changes to the Schedule K-2 and K-3 instructions in January of 2022 confirmed that the IRS expects a broad and deep pool of pass-through entities will add these schedules to returns in 2021. More taxpayers and more required disclosures will increase the time and effort for tax return preparation.
We encourage you to talk with your Cherry Bekaert tax advisor, or one of our International Tax Advisory professionals, to plan for your pass-through entity’s compliance with Schedules K-2 and K-3 reporting.