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Major changes to 2021 Partnership Instructions for Schedules K-2 & K-3

UPDATE (2/16/22)

The IRS is providing an additional exception for tax year 2021 to filing the Schedules K-2 and K-3 for certain domestic partnerships and S corporations. To qualify for this exception, the following must be met:

  • In tax year 2021, the direct partners in the domestic partnership are not foreign partnerships, foreign corporations, foreign individuals, foreign estates, or foreign trusts. 
  • In tax year 2021, the domestic partnership or S corporation has no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably expected to generate foreign source income (see section 1.861-9(g)(3)).
  • In tax year 2020, the domestic partnership or S corporation did not provide to its partners or shareholders nor did the partners or shareholders request the information regarding (on the form or attachments thereto):
    • Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S), and
    • Line 20c, Form 1065, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, section 250, section 864(c)(8), section 721(c) partnerships, and section 7874) (line 17d for Form 1120-S).
  • The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.

The IRS recently announced substantial changes to the 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065). These changes will likely impact those who typically file by the March 15th deadline.

What’s Changed?

For the 2021 tax year, the IRS has introduced new Schedule K-2 and K-3 forms for partnerships and S Corporations. These forms were created to report certain international income, deductions, and credits. According to the IRS, these new forms are intended to provide additional clarity to investors on how to properly calculate their US tax liability on specific international items. 

Who is Impacted?

Anyone who files Forms 1065, 8865, and 1120-S will be impacted by these changes. The new schedules are primarily focused on international tax items; however, the new ruling requires them to be filed even if the entity is only operating domestically with only US owners. The increased reporting is intended to provide more detailed data around the type and source of income to help partners and shareholders correctly calculate foreign tax credits and other assorted international calculations.

What else will I need to provide?

Due to the additional information reporting requirements, additional documents that taxpayers may not have previously needed to prepare their taxes could now be applicable.

Are there exceptions?

At this point, there are very few exceptions that would allow a partnership to not file the K-2 and K-3 for each of their investors. Failing to file complete and accurate Schedules K-2 and K-3 can trigger penalties, which vary based on the number of shareholders or partners the entity has.

Next Steps

With such a significant change occurring well into the tax filing season, we expect this process to delay those who file on the March 15th deadline. At this time the majority of tax software providers used by accounting firms (including YHB’s) do not expect that they will have final, fileable forms available until the end of March. This means that many will most likely not be able to finalize tax returns by the March 15th filing date. While we will be able to provide you with K-1s for each of the investors by March 15th, we do not expect to be able to complete e-filed K-2 and K-3 forms until after the deadline.

Our team at YHB is here to assist in filing extensions and will provide additional information as we learn more. Please don’t hesitate to reach out to your YHB team member.