Schedules K-2 and K-3: 2022 Filing Guidance

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.

BROOKS: Welcome to this edition of the Cherry Bekaert Tax Beat podcast. Today's conversation is focused on Schedules K-2 and K-3 for partnership and S corporation tax returns. These forms were introduced in conjunction with 2021 returns, and now we're in our second year of including these schedules in most returns for tax year 2022.

BROOKS: We'll talk a little about the history for why the IRS introduced these schedules and spend a lot of time focusing on exceptions that many businesses are looking for to escape this compliance burden. Joining today's conversation is Mike Elliott, Director on our firm's National Tax Team. Good afternoon, Mike.

MIKE ELLIOTT: Hey, Brooks. Good morning.

BROOKS: Also joining us, as always, Sarah McGregor, Director in our Greenville office. Ms. McGregor, how's life treating you?

SARAH MCGREGOR: Life is good. The Super Bowl is over. It was a very interesting and well-played game. I guess now the rest of tax season goes on.

BROOKS: I'm sure they're all crying in Philadelphia today. So, let's move on to today's topic. A little background: in July 2021 the IRS formally introduced Schedules K-2 and K-3. Broadly speaking, these schedules are about supplemental information on foreign activity, the tax implications of foreign activity, and financial consequences. That information was usually reported in a series of statements attached to the partner or shareholder Schedule K-1. This was a more formalized approach.

BROOKS: Prior reporting was, some might argue, chaotic, sporadic, and inconsistent. Schedules K-2 and K-3 were designed to bring uniformity, consistency, and higher standards to reporting items of international tax relevance. In the big picture, these schedules impact the underlying taxpayer more than the pass-through entity itself. That may not be true all the time, but it's the general rule.

BROOKS: Until the 2021 tax return instructions were released, many pass-through entities that did not conduct or invest in international activities assumed that Schedules K-2 and K-3 were irrelevant to them. The forms say international and foreign all over them, so simple domestic businesses thought they would not have to file them. The instructions were a surprise and required broad compliance: if there's any possibility that any owner might need this information for international tax calculations, then you have to prepare Schedules K-2 and K-3. That interpretation shocked much of the tax community and frustrated many business owners.

BROOKS: Taxpayers and return preparers pushed back hard to get relief. Mike, tell us a little about the relief taxpayers got last year, because I think that rolls forward into this year.

MIKE ELLIOTT: One of the first things that happened is the IRS released Notice 2021-99. The notice provided relief for a good faith effort. That means certain affirmative actions are required by the partnership and the return preparer. You can't simply avoid filing the schedules because you don't feel like doing it. You must show you tried to determine whether anyone would need the information and that you satisfied yourself that no one likely needs it.

MIKE ELLIOTT: If you determine someone may need the information, you must make a good faith effort to report that information accurately. As long as the partnership and preparer can show the IRS they made a good faith effort to comply with the new requirements, they generally would not face penalties.

SARAH MCGREGOR: Why is it important that a taxpayer go through this effort and think about filing Schedules K-2 and K-3 correctly for a tax return?

MIKE ELLIOTT: There are several reasons. There can be penalties for failure to file timely, correct, or complete tax returns. We can't rely on Notice 2021-99 anymore for 2022 returns. We may also have to provide this information later if somebody asks for it, and the statute of limitations may not start if we don't file a complete and correct return that includes all required information.

MIKE ELLIOTT: If we get a notice later saying you should have filed Schedules K-2 and K-3, you may have to resubmit your return. That could restart the statute of limitations and possibly require filing an administrative adjustment request, which is more involved than if you had filed correctly the first time.

SARAH MCGREGOR: There can be penalties associated with each Schedule K-1 that was supposed to have a Schedule K-3 attached, and there's a penalty for each month those are outstanding as well.

MIKE ELLIOTT: Yes. Those can rack up quickly.

BROOKS: I want to add that while much of our conversation considers these schedules a compliance burden, it's important to note that when the information matters, it is important to follow Schedules K-2 and K-3 correctly. There are cases where this information is necessary for calculations on the underlying taxpayer's return. The purpose of this discussion is not in-depth international tax, but there are situations where these schedules are essential.

BROOKS: Anyway, moving on: you've set the background on 2021 returns with the notice. For 2022 returns, what's the landscape now, Mike?

MIKE ELLIOTT: For final 2022 partnership and S corporation tax returns, the instructions for Schedules K-2 and K-3 were published in December. Now we know what the IRS expects for 2022. There are two exceptions for filing Schedules K-2 and K-3. Pass-through entities are off the hook only if they meet at least one of these exceptions: the domestic filing exception or the Form 1116 exception. I'll explain both.

BROOKS: Let's dig deeper into the domestic filing exception.

MIKE ELLIOTT: There are four tests that must all be met to qualify for the domestic filing exception. If you miss any one, you do not qualify.

MIKE ELLIOTT: First, you must have either no foreign activity or only limited foreign activity. Second, all owners must be U.S. citizens or residents, or domestic trusts or estates with U.S. grantors or decedents and U.S. beneficiaries, or an S corporation with only one shareholder, or a disregarded taxable entity that is wholly owned by one of the previously described taxpayers. You cannot have any partners or shareholders other than those described.

MIKE ELLIOTT: Third, notification must be made to partners that they will not receive a Schedule K-3 from the partnership unless they specifically request it. Fourth, there cannot be any requests from partners on or before the one-month date, which is exactly one month before the partnership or S corporation files its tax return for 2022. If anyone requests a Schedule K-3 at least 30 days before the return is filed, you do not meet the domestic filing exception.

SARAH MCGREGOR: The notice-to-partners requirement was originally a more complicated communication and process, but the final instructions made it easier.

MIKE ELLIOTT: Yes. Under the final instructions, the pass-through entity can attach a statement with the Schedule K-1 saying we are not filing Schedules K-2 and K-3. This is a welcome change because the original draft instructions would have required partnerships to send notification earlier, effectively two months prior to the original due date.

MIKE ELLIOTT: To reiterate the owner limitations: you must have only U.S. citizen or resident owners or domestic trusts or estates. If you have even one upper-tier partnership, one C corporation, one S corporation with multiple shareholders, one foreign partner, or any disregarded tax entity owned by any of those types of taxpayers, you do not meet the requirement.

MIKE ELLIOTT: Regarding limited foreign activity, the only allowed foreign activity is passive category limitation income, and no more than $300 of foreign tax that must have been reported to the partnership on a Form 1099. If you have any other type of foreign source income, you do not meet the domestic filing exception.

MIKE ELLIOTT: If one partner or shareholder requests a Schedule K-3 on or before the one-month date, you are out of the domestic filing exception. If you do not meet the domestic filing exception, you might qualify for the Form 1116 exception, which requires confirmation from each owner that none of them will be filing Form 1116 to claim a foreign tax credit.

MIKE ELLIOTT: Individuals, in limited circumstances, can claim a foreign tax credit directly on their return without filing Form 1116 if the amount is small. If you can confirm that no partner or shareholder will file Form 1116, and you obtain that confirmation from the partnership or S corporation, you may meet the Form 1116 exception and not have to file Schedules K-2 and K-3.

MIKE ELLIOTT: If you do not meet either exception, you do not have an official basis to avoid filing. That does not necessarily mean penalties will be imposed, but you lack a formal safe harbor.

SARAH MCGREGOR: Mike, if a partnership or S corporation doesn't qualify or doesn't want to go through the hassle of confirming the Form 1116 exception or meeting the domestic filing exception, is it very difficult to complete and file Schedules K-2 and K-3?

MIKE ELLIOTT: No, it's not terribly difficult. In many situations, it's not hard to file the schedules. If you can't meet an exception, it's often easier to go ahead and file Schedules K-2 and K-3 rather than hope nobody requests the information later.

BROOKS: From a business owner perspective, you might have many partners and think the chances of this mattering are remote. But I hear you.

BROOKS: One of the problematic requirements is the no-request rule within one month of filing. How do you know you qualify at the time of filing if the test is one month prior to filing?

MIKE ELLIOTT: Ultimately, it's the taxpayer's burden to let their preparer know that nobody has requested a Schedule K-3 in the prior 30 days. When we send a return to a client for filing, they need to look back over the last 30 days. If anyone asked for a K-3 during that period, they need to let us know and not file the return until we address it.

MIKE ELLIOTT: We will send an information request when preparing the return and ask clients whether anyone has asked for a Schedule K-3. If they reply that nobody has asked, we'll proceed under that assumption and ask them to inform us immediately if that changes.

SARAH MCGREGOR: What happens if someone requests a Schedule K-3 after you filed the return or within that 30-day period, say five days before the return is filed and one partner asks for the K-3? What do you do then?

MIKE ELLIOTT: If the request occurs within the 30 days before filing—say five days before—you do not have to hold up the return because that request was not made before the one-month date. You can file the return. You will not have to attach Schedules K-2 or K-3 to the IRS filing, but you must prepare and provide a Schedule K-3 to the partner who requested it.

MIKE ELLIOTT: You must provide that Schedule K-3 by the later of the date the partnership files its return or 30 days after the request. If someone requests a K-3 five days before you file, 30 days after that request will be after filing, so you have some time to prepare it. However, once someone requests it, you will have to prepare Schedules K-2 and K-3 for all partners in the next year.

BROOKS: That nuance clarifies things. Thank you.

BROOKS: Mike, I think the most problematic area is private equity partnership returns with tiered ownership structures. You can clearly be in a domestic activity situation, but the compliance costs can be significant. What do you see partnerships doing—opting in to prepare the schedules, opting out, or trying hard not to do it?

MIKE ELLIOTT: It depends on the client, but many will likely opt in. Most clients want to do it right, especially when it's not terribly difficult for the preparer to compile the information and put it on the schedules. It can be inefficient to have to go back and produce the schedules after the fact if someone requests them, so many will choose to provide them upfront unless they're certain nobody needs them.

BROOKS: It's certainly easier to pay your CPA to do it, though it may not be the most cost effective.

SARAH MCGREGOR: Even a real estate partnership with a rental office building in one state may not know the tax situations of its investors. Even in a domestic situation, it may still make sense to provide a Schedule K-3 because you don't know how the owners' other financial activities will look.

MIKE ELLIOTT: Precisely. If someone requests it after the fact, you'll still have to provide it, which means you'll have to do the work anyway. If there's a good chance you'll need it, you might as well prepare and file it.

SARAH MCGREGOR: We did see last September and October a lot of last-minute Schedule K-1s with no Schedule K-3 attached, and we were surprised by it.

MIKE ELLIOTT: Many preparers took the position that they would not deal with it and did not provide the schedules even after we requested them. That left us to try to infer what the information would have looked like without an official schedule, which is not ideal.

BROOKS: I understand CPAs had clients that didn't want to pay for the extra work. So sometimes it's the client deciding they don't want to pay to prepare Schedules K-2 and K-3, not the CPA refusing.

BROOKS: I think it's time for final comments. Mike, the floor is yours. Final words?

MIKE ELLIOTT: Everyone needs to become familiar with this new reporting mechanism. Even though this is the second year, the IRS is putting heavier focus on it now that the notice relief does not apply. We need to make the effort to do this right, understand the requirements, and plan accordingly. These requirements were imposed on us, but in many cases the information is needed. Ultimately, partners and shareholders will need this information to prepare their own returns correctly.

BROOKS: Sarah?

SARAH MCGREGOR: I agree. As middle-market companies and portfolio-owned pass-through entities engage in more international activity, it makes sense that the IRS standardized the information flow to make compliance easier for investors preparing their tax returns. The IRS has listened to the taxpayer and preparer communities and adjusted filing instructions over time. They provided notice relief last year and reasonable opportunities to apply exceptions for truly domestically owned and operated entities.

BROOKS: I'm still conflicted. I understand the importance for entities with true international activity. For domestic-only entities, it seems like a lot to ask. I'm curious to see analysis a year or two from now on the materiality of this reporting. How much did Schedules K-2 and K-3 change foreign tax credit calculations versus the cost of compliance? We'll see if requirements ease over time to focus on situations where the information matters most.

BROOKS: That's a wrap on today's discussion on Schedules K-2 and K-3 and particularly the domestic filing exception for pass-through entities. Thank you for listening. A quick disclaimer that we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.

BROOKS: Check out the firm's website at cbh.com for the latest guidance and materials on this and other tax and business topics. This concludes today's podcast. Please like, share, and subscribe. Thank you, Mike. Thank you, listeners, for spending your time with us. We truly appreciate it. Let's call it a day and go forth in peace.