Effective for the tax year 2021 any partnership with foreign partners or with foreign activity is required to file Schedules K-2 and K-3
The Tax Cuts and Jobs Act (TCJA), passed in December of 2017, brought major reform to U.S. international tax. These changes impacted taxable income generated from offshore activity but also resulted in increased reporting requirements. Since then, tax practitioners have been trying to hit moving targets with everchanging updates to forms and filing requirements year after year.
Among the changes to international reporting are the Schedules K-2 and K-3 which are being added to further enhance Schedule K-1 reporting.
Historically, partnerships have reported foreign activity to their partners on line 16, Foreign Transactions, and in the footnotes of the Schedule K-1. Due to the changes under TCJA, as well as the ever-increasing offshore activity of U.S. taxpayers, the IRS identified the need to bring some consistency to how partnerships report foreign activity. The new format is intended to streamline the presentation of information necessary for partners to comply with all necessary filing requirements.
A partnership is only required to provide Schedules K-2 and K-3 if it has operations with international tax relevance, which includes international activities, foreign partners with reporting obligations or withholding tax. If a partnership does not have international tax relevance, the new forms are not required.
Schedule K-2 is in addition to the Schedule K of Form 1065 and is used to report foreign operations at the partnership level. Schedule K-3 is in addition to a partners Schedule K-1 and is used to report a partner’s allocable share of amounts reported on Schedule K-2. The new Schedule K-3 is intended to replace, supplement, and clarify information reported to partners in order to help them comply with their foreign reporting obligations. Schedule K-3 is required to be provided to partners in the same timeline as their Schedule K-1.
Impact to Investment Partnerships
Investment partnerships who pay taxes to a foreign jurisdiction generating a foreign tax credit own an interest in a controlled foreign corporation, compute Global Intangible Low-Tax Income (GILTI) and Subpart F income (Part VI), or receives a distribution from a foreign corporation will be required to disclose supplemental information on Schedules K-2 and K-3.
Another area of the Schedule K-2 and K-3 that investment partnerships will focus on is Passive Foreign Investment Company (PFIC) reporting. Previously, all PFIC reporting information was provided in the Schedule K-1 footnotes, the Schedules K-2 and K-3 require the partnership to provide all PFIC information via Part 7. Fortunately, the same exceptions to PFIC reporting still apply to Schedules K-2 and K-3 PFIC reporting. A domestic partnership that has made an election to treat a PFIC as a pedigreed Qualified Electing Fund (QEF) or made a Mark-to-Market (MTM) election is not required to complete Part 7 of Schedules K-2 and K-3 provided the partnership files Form 8621 for the PFIC.
The Schedule K-2 and K-3 reporting requirements do not eliminate a partnership’s requirement to furnish withholding forms where applicable. Forms 8804 and 8805 are still required to be withheld for and filed when effectively connected income is allocable to foreign partners; the information will now also be included in Schedules K-2 and K-3. Similarly, Form 1042 and 1042-S filing obligations are also still applicable. If a partnership with foreign partners receives US-sourced FDAP payments, it will include this information on part 10 of the Schedule K-2 and K-3 and will also report and withhold where necessary on Form 1042 and 1042-S.
The transition to reporting additional detail on the Schedule K-2 and K-3 may be initially challenging for partnerships. However, the hope is that the transition will benefit the partners and the increase efficiency in the IRS’s processing of the taxpayer’s information.
Penalties may apply for filing a tax return without all the required K-2 and K-3 Schedules. The same penalties that apply regarding Schedule K-1 apply with respect to Schedules K-2 and K-3, namely $195 per incorrect or incomplete Schedule for each month during failure (not to exceed 12 months). Additional penalties may apply for failure to provide Schedule K3 to each partner. However, because 2021 is the initial year and implementing the new filing requirement may pose some challenges, the IRS does offer relief for taxpayers that make a good faith effort to comply for 2021 under IRS Notice 2021-39.
Contact Withum’s team of professionals if you have any questions or concerns.