Business Owners: IRS Issues Updated K-2 and K-3 Requirements

by | Feb 15, 2022

February 16, 2022 – The IRS has updated guidance on additional exceptions to the new K-2 and K-3 filing requirements. See FAQ #15 found here.

In late 2021, the IRS added new schedules K-2 and K-3 for tax year 2021 for partnerships and S corporations (flow-through entities). Until recently, these new schedules were required only for flow-through entities that have foreign activity, which is a relatively small population of taxpayers.

The modified K-2 and K-3 instructions that were released in January 2022 now require nearly all flow-through entities to comply with these new reporting requirements. The criteria for filing schedules K-2 and K-3 focus mainly on whether or not taxpayers may require the information reported in order to properly comply with their foreign tax reporting. Even if this foreign tax reporting does not arise from the activities of a flow-through entity, an investor may still require certain schedule K-3 information in order to determine his or her foreign tax reporting from other investments or direct activities. For instance, schedules K-2 and K-3 generally must be completed to determine if an investor is eligible to claim the foreign tax credit on Form 1116. Form 1116 is commonly used by taxpayers who have foreign investments held in brokerage accounts that pay foreign tax to receive a credit on their U.S. tax returns.

As originally written, this requirement would affect a small portion of our client base. As recently modified, it is very possible that schedules K-2 and K-3 may be required even if the flow-through entity does not have any foreign activities or foreign partners. We now believe this will affect a large population of KHA clients.

New schedules add new compliance considerations. We will be relying on our software providers to update their systems to comply. The IRS must communicate with software providers who will need time to design the new software to incorporate new schedules into the tax return packages. Schedule K-2 is comprised of 19 pages of information, and each Schedule K-3 (one required per partner or shareholder) is comprised of 20 pages of information.

The IRS has communicated that the new electronic filing schemas should be available around mid to late March for partnerships and June for S corporations. CCH, one of the three largest tax software companies in the nation and the software provider we use, has provided a provisional e-file release date of late April for partnerships and summer for S corporations.

Understanding the significance of this change for many flow-through entities, the AICPA and the largest CPA firms in the US are lobbying the IRS to make changes to this rule and provide relief to smaller businesses. We’re hopeful that relief might come, but we can’t guarantee that it will.  As new information becomes available regarding these IRS filing requirements, we will provide updates.

These sources are simply included for informational purposes. KHA Accountants, PLLC, its partners and others do not provide any assurance as to the accuracy of these items or the information included therein. As such, KHA Accountants, PLLC cannot be held liable for any information derived from referenced sources. This is intended for illustrative and discussion purposes only.

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