The IRS announced a year ago that there would be two new forms for partnerships and S-Corporations with international income and/or partners: Schedules K-2 and K-3 (links are to the partnership versions of these forms). Most tax professionals would have a return or two that had to deal with these new schedules; no one believed it would be a big deal. Indeed, the original IRS instructions for these forms confirmed that.
And then the IRS changed the instructions. Most of these changes are technical and of little concern to the public. However, the IRS made a major change related to the interaction of these schedules and Form 1116 and Form 1118 (Foreign Tax Credit). The change–which I’ll detail below–means that almost every partnership (and many S-Corporations) will need to complete at least a portion of these new schedules.
The IRS added an example in the new instructions of when a partnership does not need to complete Schedules K-2 and K-3:
Example. U.S. citizen A and U.S. citizen B own equal interests in domestic partnership. In Year 1, domestic partnership has no foreign source income and no assets that generate foreign source income. Domestic partnership does not pay or accrue foreign taxes. In Year 1, U.S. citizen A pays $100 of foreign income taxes on passive category income which was reported to U.S. citizen A on a qualified payee statement. U.S. citizen A does not pay or accrue any other foreign taxes and has no other foreign source income. U.S. citizen B does not pay or accrue foreign income taxes. In Year 1, because U.S. citizen B paid no foreign taxes for which it can claim a foreign tax credit and U.S. citizen A qualifies for the exemption from completing Form 1116 to claim a foreign tax credit and such information was provided to domestic partnership by both U.S. citizen A and U.S. citizen B, domestic partnership need not complete Schedules K-2 and K-3, Part I, box 1, box 2, box 3, box 4, box 5, and box 10, Parts II or III.
In English, this means that if a tax professional is certain that no partner is taking a foreign tax credit where Form 1116 or Form 1118 is completed, then Schedules K-2 and K-3 do not need to be completed. The problem is that in almost all cases, tax professionals will not know this and will have no way of knowing this!
Form 1116 is exempt on a personal return if you have $300 or less in foreign taxes paid ($600 if married filing jointly). Consider Acme Partners–with Bill, Jane, and Ralph as partners. It has no foreign activities at all, so you would think it would be exempt from Schedules K-2 and K-3. Bill and Jane have no foreign income of any sort. Ralph, though, invests in lots of partnerships that issue him K-1s. Some years he’s had $1,000 of foreign tax paid; other years, it’s $10. Ralph isn’t on good terms with Bill and Jane, but Ralph is still a partner. Russ is the tax professional, and he deals with Bill in getting the return prepared. Russ can ask Bill, “Will any of the partners file Form 1116?” We have a number of issues:
- Whether Form 1116 is required might not be known until each partner receives all of his or her K-1s (and that can be in mid-September). There’s an obvious circular issue here: Whether a partner needs to file Form 1116 depends on all the K-1s (and K-2/K-3s), but you’re preparing a K-1 (and K-2/K-3).
- What if a partner refuses to discuss this with the “Tax Matters Partner?” Conflict of interest rules under Circular 230 (the regulations governing tax professionals) likely prohibit the tax professional from asking the recalcitrant partner.
- What if one or more partners honestly doesn’t know?
- Why should a partnership with only US activities complete Schedules K-2 and K-3 given that (a) there is no international activity; (b) there are no foreign partners; and (c) the IRS can accurately determine the income and expenses of the partnership (and accurately determine each partner’s share of income) from the return and the Schedule K-1. Additionally, any partner who is filing Form 1116 can accurately complete it using Schedule K-1 for a US-only partnership.
- Completing Schedules K-2 and K-3 will add time and cost to any partnership return.
- As of today, the IRS estimates it will be ready to accept efiled Schedules K-2 and K-3 for partnerships on March 17th (partnership returns are due on March 15th). It’s even worse for S-Corporations: the IRS is estimating it will be ready for those Schedules K-2 and K-3 in the May to June time-frame (S-Corporation returns are due on March 15th, too).
- The IRS is allowing “transition relief” for 2021 returns, but a “good faith” effort is supposed to be made to prepare the new schedules.
There are only three solutions that I can see. The first–and best–is that the IRS simply state that a partnerships and S-Corporations with no foreign activity or partners need not file Schedules K-2 and K-3. The reality is that the IRS does not need such partnerships (and S-Corporations) to complete the forms in order to determine whether a partner’s (or S-Corporation shareholder’s) Form 1116 (or Form 1118) was completed accurately. The second possible solution is for the IRS to allow a statement to be attached to the return stating that the partnership has no foreign income (similar to the de minimis property regulation statement). The third solution is just to postpone Schedules K-2 and K-3 until the 2022 tax year so that a workable solution can be found.
If the IRS continues down their current path, I do not see a way around preparing Schedules K-2 and K-3 for almost every partnership. For perhaps 10% of the partnership returns we prepare, we also prepare all partners’ tax returns (most of those are husband-wife partnerships); for those, we can determine if we must prepare Schedules K-2 and K-3. For the other 90%, I will have no choice but to prepare these schedules. This will add at least 20 minutes of work for each return (possibly more), and that will add to every client’s bill. Additionally, all of these partnerships will have to go on extension. And by the time March 17th comes and I can efile the returns, we’ll be buried in personal returns.
The issue is less of one for S-Corporations. Perhaps half of the S-Corporation returns we prepare are one-owner returns. For those, we know whether they need to include Schedules K-2 and K-3. Still, we will have many impacted returns; all of those returns will need to be extended (and the owners’ personal returns will all have to be extended).
This was already shaping up to be a miserable Tax Season. This change is only going to make miserable year turn nightmarish. If anyone from the IRS reads this, please reconsider what you’ve done or postpone it a year.
Tags: Schedules K-2 & K-3