New IRS FAQ Guidance for Pass-Through Entity Returns

New IRS FAQ Guidance for Pass-Through Entity Returns

You may have heard about some new reporting requirements for Partnerships and S Corporations that could delay preparation of your 2021 tax returns – that delay will be mitigated by recent updates from the IRS that “provided clarification and exceptions to completing the Schedules K-2 and K-3.” Learn more below.

On January 18, 2022 the IRS issued important changes to the instructions for the new Schedules K-2 and K-3 for partnerships and S corporations. If applicable, these new schedules are to be filed with 2021 tax returns for such entities. The purpose of the new reporting obligation is to provide information needed for international reporting on the U.S. tax returns of the owners of the entities. The IRS’s updated instructions clarified that even if the entity has no foreign income, no foreign taxes paid or accrued, no foreign assets, and no other foreign activities, it may still be required to file Schedules K-2 and K-3 if any of the owners of the entity are eligible to claim a foreign tax credit and need to file Form 1116 to claim the credit.

This international reporting is complex and could include up to 20 pages for each Schedule K-2 and K-3 that is required to be filed. Tax preparers and their pass-through entity clients may need to gather significantly more information about their owners’ tax filing situations, as well as identification of any indirect owners. There are penalties associated with the failure to file or report complete information. The IRS has provided limited relief from these penalties for taxpayers that make a good faith effort to comply with the new reporting requirement, but the extent to which this relief can be relied upon is unknown.

The IRS has announced that the new schedules may not be available to e-file until after the original filing deadlines for partnership and S corporation tax returns. The IRS is targeting late March for e-filing partnership returns containing Schedules K-2 and K-3, and late June for e-filing such S corporation returns. We are awaiting updates from our tax return software provider for full functionality in preparation of Schedules K-2 and K-3.

The good news: On February 16, 2022 the IRS provided an 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.
• 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 certain information regarding reporting of international activities.
• The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.

We believe this exception for the 2021 tax year may be met for many Herbein clients filing partnership and S corporation tax returns. If so, these eligible entities will not need to file Schedules K-2 and K-2 with the IRS or with its partners or shareholders.

However, should Schedules K-2 and K-3 be required for the 2021 tax year, taxpayers should anticipate additional time and fees related to this additional reporting requirement. Also, as noted above, the timeline for filing and delivery of tax returns and Schedule K-1’s could be impacted.

Your Herbein advisor will be in touch regarding updates and the best approach that suits your facts and circumstances, but please feel free to reach out if you have any additional questions or concerns at info@herbein.com. 

Article compiled by Elizabeth Hassler.