Posts Tagged ‘Schedules K-2 & K-3’

IRS: On Third Thought, Let’s Grant “Relief” That Isn’t

Thursday, February 17th, 2022

Yesterday, I wrote a post stating the IRS was giving relief on the new Schedules K-2 and K-3.  I did that because I believed what the IRS wrote.  The IRS stated:

Coming relief from certain Schedule K-2 and K-3 reporting: The IRS intends to provide certain additional transition relief for this year from the Schedule K-2 and K-3 reporting for certain domestic partnerships and S corporations with no foreign activities, foreign partners or shareholders, and without knowledge of partner or shareholder need for information on items of international relevance. For 2021, these qualifying domestic partnerships and S corporations will not have to file the new schedules. We are taking this step in response to feedback we received from the tax community and our stakeholders. The IRS will provide full details of this relief soon.

Silly me, taking the IRS at their word.  The IRS did indeed add an FAQ on Schedules K-2 and K-3 detailing the relief.  That relief is noted in question 15, but if you read questions 10 – 12 that relief vanishes.  The IRS in question 10 states they won’t penalize taxpayers who make a “good faith” effort to comply, but in question 11 notes the same rules that can require domestic-only entities to file Schedules K-2 and K-3:

In many instances, a partnership or S corporation with no foreign partners, foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner or shareholder claims the foreign tax credit, the partner generally needs certain information from the partnership on Schedule K-3, Parts II and III, to complete Form 1116. This information should have been reported in prior years, including before the Tax Cuts and Jobs Act, on the Schedules K and K-1, and is information the partner or shareholder needs to compute the foreign tax credit limitation, which determines the amount of foreign tax credit available to the partner or shareholder.

So the reality is that nothing has changed from Monday–there is no real relief at this point.  I gave three examples of real relief yesterday: “There are three courses of action the IRS should choose among for the long-term resolution of the issue.  They could just use a de minimis threshold of somewhere between $1 million and $25 million of sales; entities with sales below that and no foreign partners and foreign operations would be exempt.  The IRS could base whether Schedules K-2 and K-3 need to be filed on the prior year’s requirements for filing Form 1116.  Or the IRS could just drop the requirement to file these forms for domestic entities with no foreign partners or operations.”  I would accept any of these (or something similar).

The problem is that I’ve dealt with the IRS in the past on “reasonable cause” issues with an international filing.  A few years ago, clients of mine timely filed (with an extension) Forms 3520 and 3520-A related to a foreign trust.  They mailed these forms using the equivalent of certified mail (neither of these forms can be electronically filed).  A year after filing, they each received a $10,000 penalty notice for late filing.  This made no sense; I had filed the extensions and had proof of that.  We wrote the IRS noting this.  One spouse had the penalties instantly removed.  The other spouse had to go to Appeals over the same exact issue, and it took 30 months before the penalties were finally removed.  (There was never an Appeals hearing–we just received a letter stating the penalties were removed.)  The clients were under stress during those 30 months from a possible $10,000 penalty and were not happy.

I do not want my clients to face draconian penalties.  Battling “reasonable cause” has been an adventure and I don’t think it will get better given that the IRS is drowning in paper.

The IRS also asked why tax professionals didn’t complain when the draft K-2 and K-3 forms and instructions were released last summer.  That’s simple: We did not think we would be impacted.  At that time, the instructions did not include any reference to a US-only entity with no foreign partners or operations needing to file these forms.  The instructions were not changed on this until late January 2022.  How do you expect tax professionals in July 2021 to know the IRS would change the rules in January 2022?

To the IRS: You need to offer real relief.  This is already an awful (likely disastrous) Tax Season.  Your actions on this matter do not inspire confidence.

IRS: “You Know That New K-2/K-3 Requirement: Well, We Had Second Thoughts.”

Wednesday, February 16th, 2022

UPDATE: Make sure you read the post of February 17, 2022 on this issue.

Every so often the IRS actually listens to the tax professional community.  Tax professionals were unanimous in stating that requiring a domestic partnership with no foreign partners and no foreign operations to complete the new Schedules K-2 and K-3 was stupid; it’s similarly stupid for an S-Corp with no foreign operations.  (I wrote about this requirement 11 days ago.)  The IRS added the following notice to a special page on the 2022 Tax Season:

Coming relief from certain Schedule K-2 and K-3 reporting: The IRS intends to provide certain additional transition relief for this year from the Schedule K-2 and K-3 reporting for certain domestic partnerships and S corporations with no foreign activities, foreign partners or shareholders, and without knowledge of partner or shareholder need for information on items of international relevance. For 2021, these qualifying domestic partnerships and S corporations will not have to file the new schedules. We are taking this step in response to feedback we received from the tax community and our stakeholders. The IRS will provide full details of this relief soon.

It;s great that the IRS realized the problems that these new schedules involve for tax professionals and taxpayers during what is sure to be a challenging Tax Season.  However, there’s still a long-term problem that needs to be resolved.

Consider Harry, a partner in a domestic partnership (call it Acme) with no foreign partners and no foreign operations.  He and his wife typically have about $400 of foreign tax paid through a different partnership he’s a partner in.  He tells the managing member of Acme that for 2022 (next year’s taxes filed in 2023) he doesn’t have a Form 1116 filing requirement.  Acme timely files its 2022 return and doesn’t include Schedules K-2 and K-3.  In September, Harry receives the other partnership’s K-1, K-2, and K-3 and discovers that this year there was $610 of foreign tax paid.  Does Acme now have to amend its 2022 returns?  Is Acme subject to draconian penalties even though the partner had no way of knowing about the Form 1116 requirement? 

There are three courses of action the IRS should choose among for the long-term resolution of the issue.  They could just use a de minimis threshold of somewhere between $1 million and $25 million of sales; entities with sales below that and no foreign partners and foreign operations would be exempt.  The IRS could base whether Schedules K-2 and K-3 need to be filed on the prior year’s requirements for filing Form 1116.  Or the IRS could just drop the requirement to file these forms for domestic entities with no foreign partners or operations.

Unfortunately, I suspect all that’s happened is the problem has been postponed one year.

The K-2/K-3 Kerfuffle

Saturday, February 5th, 2022

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:

  1. 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).
  2. 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.
  3. What if one or more partners honestly doesn’t know?
  4. 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.
  5. Completing Schedules K-2 and K-3 will add time and cost to any partnership return.
  6. 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).
  7. 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.