Significant Changes to IRS Foreign Reporting Requirements (Schedules K-2/K-3) – Relief May be Available

In an effort to enhance and streamline the reporting of foreign information for taxpayers that receive pass-through income from partnerships and S corporations, the IRS has released 39 pages of new forms for the 2021 tax year. As part of these entities’ tax return, partnerships and S corporations will now need to report items of “international tax relevance” on the new Schedule K-2. Partners, members, and shareholders of pass-through entities that have items of international tax relevance should anticipate receiving a new Schedule K-3, reporting their allocable share of the international information, in addition to the Schedule K-1 customarily provided.

The IRS issued guidance at the end of January clarifying the scope of taxpayers that this international reporting applies to (the IRS subsequently issued relief discussed below). In general, entities that have items of international relevance are required to complete these new forms. In addition, entities whose partners, members, or shareholders that may have other items of international relevance aside from the pass-through entity, either through direct or indirect ownership, are also required to complete these new schedules. A common item of international relevance for many taxpayers is the foreign tax credit claimed on Form 1116. If an entity does not have sufficient information about its partners, members, or shareholders to determine if the foreign information is required, the entity must presume that it is required and as such would need to complete the new schedules.

The following example illustrates the reporting requirement:

A limited liability company, Blackacre LLC, is owned equally by Partner A and Partner B. The sole profit and loss from the entity is rental income from a property in New York City. The entity has no other income producing assets or income streams. Both partners file Form 1116 and claim foreign tax credits on their personal tax returns. Blackacre LLC is required to provide a Schedule K-3 to both partners and complete Schedule K-2 as part of the entity return.

Due to the compliance burden of these new forms, on February 16th the IRS provided transitional relief for tax year 2021 for certain qualifying taxpayers. This relief will help ease the compliance transition for pass-through entities. To be excepted from the current year filing requirements, the following must apply:

• The entity has no direct foreign partners, members, or shareholders;
• The entity has no foreign source activity;
• The entity did not report any foreign tax information on its 2020 tax return and no partner or shareholder requested such foreign tax information; and
• The entity has no knowledge that any of their partners, members or shareholders are requesting this information for tax year 2021.

However, if a member, partner, or shareholder requests foreign reporting information prior to the filing of the tax return, the pass-through is obligated to prepare Schedule K-2 and provide Schedule K-3 to all partners, members, or shareholders. If the request is made subsequent to filing the tax return, the entity is only obligated to provide Schedule K-3 to the requesting party.

For more information regarding your Schedule K-2 and K-3 reporting requirements and how the transitional relief for the 2021 tax year may apply to you, please contact your Anchin Relationship Partner.