IRS Makes Important Clarifications for Schedules K-2 and K-3 Reporting

Last month, the Treasury and the IRS provided clarifying language for Schedules K-2, Distributive Share Items – International, and K-3, Share of Income, Deductions, Credits, etc. – International. If you recall from our blog post from October, Schedules K-2 and K-3 are new for the 2021 tax year and are intended to replace, supplement, and streamline the reporting of certain amounts.

Schedule K-2 will be an extension of Schedule K and will be used to report items of international tax relevance from the operation of a partnership or S corporation.  Schedule K-3 will be an extension of Schedule K-1 and will be generally used to report a partner or shareholder’s share of the items reported on Schedule K-1. 

Some of the most notable changes to the Schedules’ instructions, which are found on second page of the “Who Must File” section, are for entities with purely domestic operations and for owners that have a reporting requirement, except in limited circumstances. The IRS clarified the need for Schedules K-2 and K-3 if a partner or shareholder can claim a foreign tax credit and must file Form 1116 or 1118 to claim such a credit. This requirement was previously included on the seventh page of the previously issued instructions. Later in the instructions, there is an example where none of the partners file a Form 1116. One partner has no eligible foreign credits and the other partner has $100 of eligible foreign credits, which can be claimed without filing Form 1116. In this example, no additional parts are needed and Schedules K-2 and K-3 are not required to be filed.   

As a reminder, individuals may elect to claim a foreign tax credit without filing Form 1116 if all of the following are met:

• All foreign-sourced gross income is qualified passive income;
• All foreign-source income and foreign taxes are reported on a qualified payee statement, such as Form 1099, Schedule K-1 (1041), K-3, or substitute form; and
• The amount of creditable foreign tax paid / accrued by the individual during the taxable year does not exceed $300 (or $600 for married filing jointly).

For additional information, including examples, on the IRS’ recent Schedules K-2 and K-3 guidance, please click here.

Source: IRS.gov