Beginning in 2021, you may need to provide the IRS extensive information on the international aspects of your partnership. However, with these new partnership tax filing requirements, you may also be eligible for penalty relief.
Key insights
- Reporting international transactions and issues for partnerships will expand considerably, beginning for tax year 2021.
- Information previously reported on certain lines of Schedules K/K-1 will soon be reported on the new Schedules K-2 and K-3, which comprise a total of 40 pages.
- Penalties of up to $10,000 per entity, per year can be assessed for failures to correctly file these new schedules, but penalty relief may be available for taxpayers that make a “good faith effort.”
- Though less stringent requirements apply to 2021, the “good faith effort” still involves significant effort that taxpayers should begin now.
Need help determining your 2021 partnership filing requirements?
Preparing tax returns for entities and individuals with multiple partnership investments is often complicated and messy — especially when your partnership has global components (e.g., foreign ownership, buy and sell internationally, are set up offshore, invest in foreign entities, etc.).
The foreign transactions section of Schedule K and K-1 can be difficult to follow and complete, even for U.S. international tax professionals. Recent international regulations, such as global intangible low-taxed income and foreign-derived intangible income (GILTI and FDII), require additional disclosures on Schedules K and K-1, some of which find their only home in a K-1 footnote. In an effort to facilitate consistent and transparent reporting, the IRS designed new Schedules K-2 and K-3 to “replace, supplement and clarify” the reporting for these foreign-related amounts.
No simplification or reduction
The new schedules, which were released on June 3, do not simplify or shorten the reporting process. Lines 16a-16r (and 14a-14r on Form 1120-S*) on Schedule K have ballooned to 19 pages on the final Schedule K-2, with the Schedule K-1 reporting expanding to a 21 page Schedule K-3. The Schedule K-3 will be replicated for and sent to each partner, along with the rest of the “K-1 package.” And while the new Schedule K-3 may clarify international issues for the partner, that clarification will come at significant cost to the partnership in learning to properly prepare Schedules K-2 and K-3.
Who is required to file the new schedules?
Fortunately, not all partnerships are required to file Schedules K-2 and K-3. According to the latest draft instructions released on June 30, 2021, partnerships “need not complete this schedule if the partnership does not have items of international tax relevance (typically, international activities or transactions, foreign subsidiaries, or foreign partners).”
The 12 parts of Schedules K-2 and K-3 are fairly comprehensive in their attempt to address any and all international issues that could impact the partner’s tax return, including:
- Allocation and apportionment of gross income and deductions for calculating partners’ foreign tax credit
- Information to calculate corporate partners’ FDII deduction
- Passive foreign investment company (PFIC) information to complete partners’ Forms 8621
- Foreign partners’ distributive share of deemed sale items on transfer of partnership interest
- Other miscellaneous international information
Penalties
You can be assessed various penalties for failing to properly file the new Schedules K-2 and K-3. These include penalties for failure to:
- File or show information on a partnership return
- File correct information returns
- Furnish correct payee statements
- Furnish information required under Section 6038, which could result in a $10,000 penalty per entity, per year
It can be difficult to determine compliance requirements
Whether or not international tax issues are relevant to the partnership can often depend on characteristics and activities of the individual partners.
For example, “if a partnership has a direct or indirect partner that is a nonresident alien individual or a foreign corporation, the partnership must complete Form 1065, Part X of Schedules K-2 and K-3.” Also, “a partnership is expected to collaborate with its partners to identify the foreign related parties of each partner,” in order to properly complete Part IX of Schedules K-2 and K-3.
In other situations, information must be reported on Schedules K-2 and K-3 only if relevant to one of the partners. Based on draft instructions, “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.”
Transition relief for good faith effort
Notice 2021-39 provides penalty relief for tax years beginning in 2021 with respect to the new Schedules K-2 and K-3 — noting that the IRS is “aware that a Schedule K-2/K-3 filer may not currently have systems or procedures in place to obtain information about its partners, shareholders, or the CFP [controlled foreign partnership] to determine” applicable filing requirements.
A Schedule K-2/K-3 filer will not be subject to the relevant penalties if the filer establishes “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).”
In determining whether the filer made a good faith effort, the IRS will consider the following factors:
- Extent to which the filer has made changes to its systems, processes, and procedures for collecting and processing relevant information
- Efforts made to obtain information from partners, shareholders, or the CFP, including steps taken to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of relevant information
- Reasonableness of assumptions made when information is not obtained
- Level of influence the filer has with respect to the partnership and other partners (e.g., a partner that manages or controls a partnership will be held to a higher standard than a partner holding a less than 1% interest)
Where to begin
Start by determining your tax compliance obligations and gathering the information you need now. Work with a global tax advisor who can:
- Identify which parts of Schedules K-2 and K-3 you must file for 2021, and what information you will need to complete those parts
- Discuss sources of the relevant information and assess the capabilities of your current systems and procedures to obtain the information
- Suggest changes to and/or review amended partnership or S corporation agreements
- Assist in gathering information for, and preparing, required Schedules K-2 and K-3
How we can help
Our global tax solutions team understands the intricacies of doing business abroad and can help you narrow the gap between the ever-increasing burden of these new schedules. As we strive to help you mitigate your exposure to penalties, we never lose sight of your business objectives.