In alignment with IRS requirements, there are certain businesses that must file Schedule K-2 and Schedule K-3. Ultimately, any pass-through entities that have relevant international income, deductions, credits, or other miscellaneous items must submit completed Schedule K-2 and Schedule K-3 forms.
What is Schedule K-2 and Schedule K-3?
Schedule K-2 is associated with Partner's Distributive Share Items—International, while Schedule K-3 is categorized as Partner's Share of Income, Deductions, Credits, Et Cetera—International. Any taxpayers who file Forms 1065, 1120-S, or 8865 must also fill out the documents' accompanying worksheets.
Both Schedules K-2 and K-3 were initially designed to take the place of documentation that is already part of Schedules K and K-1. Introduced just in time for the 2021 tax year, Schedules K-2 and K-3 can also replace various filing requirements of domestic partnerships and those who claim foreign tax credits.
Any and all failure to comply with the new schedules could potentially trigger the application of certain penalties according to Internal Revenue Code Sections 6698, 6721, and 6722. It is important to mention that domestic partnerships supported with domestic income only, as well as domestic assets, may have to complete the relevant section of Schedule K-2 and Schedule K-3 if the entities have partners who are planning to claim the foreign tax credit.
Before Schedules K-2 and K-3 were put forth, a lot of the information that is now required to be provided on Schedules K-2 and K-3 was originally reported as part of Schedules K and K-1. Even though Schedules K-2 and K-3 technically encompass the reporting of items that are of additional tax relevance, these forms do not provide a clear nor concise definition of what this term means in application.
Here are a few examples of information that Schedules K-2 and K-3 ask for in the context of international relevance, all of which were originally required to be reported as part of Schedules K and K-1:
- Information related to foreign tax credits
- Details pertaining to the income earned by a foreign partner in the United States
- Data regarding international taxes, including but not limited to the base erosion and anti-abuse tax, foreign-derived intangible income tax, and global intangible low-taxed income tax
According to IRS Notice 2021-39, transitional relief is available to taxpayers who have the means to prove that they made an intentional effort to ensure they are in compliance with the updated requirements.
The IRS has done so by updating its systems, simplifying processes, and making procedures easier to follow. Changes have been made to partnership agreements and various other governing documents as a way of making the process of gathering relevant information easier than before.
The notice also emphasizes the IRS's position regarding Schedules K-2 and K-3, which is that the information provided as part of these documents must be included as part of all white paper statements, such as the footnotes for Schedule K-1.
Completing either Schedule K-2 or Schedule K-3 will be complicated, namely because filling out these documents requires that you have an in-depth understanding of international tax concepts. That's why entities that find themselves needing to complete one if not both of these forms should consult their tax adviser for assistance.
Differences between Schedule K-2 and Schedule K-3
Additionally, there are four details that you should be mindful of and familiar with:
- Schedule K-2 comprises 19 pages, which are broken down into 11 individual parts. The sections pertaining to international activities must be filled out accordingly. Schedule K-3, which is separated into 12 parts, is similar to Schedule K-2 in that both Schedules K-2 and K-3 require you to complete various tables and worksheets.
- As an affected entity, you must make sure that your partners are documented properly in accordance with either Form W-8 or W-9.
- Take a look at the discrepancies between your current process for reporting international information and the new standards as required by Schedules K-2 and K-3.
- Give yourself plenty of time to receive proof of relevant information or additional documentation from all related entities prior to the deadline for submitting Schedules K-2 and K-3.
Ultimately, Schedules K-2 and K-3 will offer more clarity for shareholders and partners alike as they go about calculating their total US income tax liability, in addition to all international-related income, as well as any applicable deductions. If this applies to you, your R&A professional can provide guidance.