The IRS announced additional relief for pass-through entities required to file two new tax forms for the 2021 tax year. Certain domestic partnerships and S corporations are exempt from IRS filing requirements of the schedules. These new tax forms, Schedules K-2 and K-3, intend to make it easier for partners and shareholders to find information related to “items of international tax relevance” that they need to file their own returns.

In 2021, the IRS released guidance providing penalty relief for filers who made “good faith efforts” to adopt the new schedules. The IRS has indicated that its latest, more sweeping move comes in response to continued concern and feedback from the tax community and other stakeholders.

A tough tax season for the IRS

IRS Commissioner Charles Rettig acknowledged that the agency faces “enormous challenges” this tax season. For example, millions of taxpayers are still waiting for prior years’ returns to be processed.

To address such issues, the IRS has taken “extraordinary measures,” he said. These include the creation and assignment of “surge teams” and mandatory overtime for IRS employees. It also incorporates the temporary suspension of the mailing of some automated compliance notices to taxpayers. The partial suspension of the Schedules K-2 and K-3 filing requirements might ease the burden as well.

New IRS filing requirements

Provisions of the Tax Cuts and Jobs Act, enacted in 2017, require taxpayers to provide significantly more information. The purpose is to calculate their U.S. tax liability for items of international tax relevance. Schedule K-2 reports such items, while Schedule K-3 reports a partner’s distributive share of those items. These schedules replace portions of Schedule K and numerous unformatted statements attached to earlier versions of Schedule K-1.

Schedules K-2 and K-3 must be filed with a partnership’s Form 1065, “U.S. Return of Partnership Income,” or an S corporation’s Form 1120-S, “U.S. Income Tax Return for an S Corporation.”

Previously, partners and S corporation shareholders could obtain the information included on the schedules. They would be able to do so through various statements or through the respective entity opted to provide, if any. The new schedules require more detailed and complete reporting than the entities may have previously provided.

The IRS surprised the tax community when it posted changes to the instructions for the schedules in January 2022. Under the revised instructions, an entity may need to report information on the schedules. Even if it had no foreign partners, foreign source income, assets generating such income, or foreign taxes paid or accrued.

For example, suppose a partner claims a credit for foreign taxes paid. Then, the partner might need certain information from the partnership to file his or her own tax return. Although some narrow exceptions apply, this change substantially expanded the pool of taxpayers required to file the schedules.

Good faith exception

IRS Notice 2021-39 exempted affected taxpayers from penalties for the 2021 tax year if they made a good faith effort to comply with the filing requirements for Schedules K-2 and K-3. When determining whether a filer has established such an effort, the IRS considers, among other things:

• The extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing the information required to file the schedules.
• The extent the filer has obtained information from partners, shareholders, or a controlled foreign partnership or, if not obtained, applied reasonable assumptions.
• The steps taken by the filer to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that’s relevant to determining whether and how to file the schedules.

The IRS won’t impose the relevant penalties for any incorrect or incomplete reporting on the schedules if it determines the taxpayer exercised the requisite good faith efforts.

Latest exception

Under the latest guidance, announced in early February, partnerships and S corporations need not file the schedules if they satisfy all of the following requirements:

• For the 2021 tax year:
  • The direct partners in the domestic partnership aren’t foreign partnerships, corporations, individuals, estates, or trusts.
  • The domestic partnership or S corporation has no foreign activity. This includes foreign taxes paid or accrued or ownership of assets that generate, have generated or may reasonably be expected to generate foreign-source income.
• For the 2020 tax year, the domestic partnership or S corporation didn’t provide its partners or shareholders — nor did they request — information regarding any foreign transactions.
• The domestic partnership or S corporation doesn’t know that partners or shareholders are requesting such information for the 2021 tax year.

Generally, filing Schedules K-2 and K-3 is not required if entities meet these criteria. But there’s an important caveat. Suppose a partner or shareholder notifies such a partnership or S corporation that it needs all or part of the information included on Schedule K-3 to complete its tax return. In that case, the entity must provide that information.

Moreover, if the partner or shareholder notifies the entity of this need before it files its return, the entity no longer satisfies the criteria for the exception. As a result, it must provide Schedule K-3 to the partner or shareholder and file the schedules with the IRS.

IRS guidance on exceptions for filing requirements

The IRS guidance on the exceptions to this filing requirement explicitly refers to 2021 tax year filings. Partnerships and S corporations should expect and prepare to file the schedules for current and future tax years. That is, in the absence of additional or updated guidance. We can help ensure you have the necessary information on hand. Contact our RRBB accountants and advisors today.

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