Schedules K-2 & K-3 Filing Relief for Pass-through Entities

For taxable years beginning in 2021, flow-through entities were required to include two new schedules K-2 and K-3 when filing their income tax returns. Schedules K-2 and K-3 replace certain portions of the Schedule K and standardize the reporting of items of international tax relevance and partners’/shareholders’ distributive shares of items of international tax relevance.

The IRS received tremendous feedback and requests for relief from the tax community expressing their practical difficulties and challenges associated with the complexity in completing these schedules, coupled with the limitations on their electronic filing options within the tax software.

In response to these requests, the IRS issued Notice IR-2022-38 and a new set of FAQs on February 16 offering additional transition relief to certain domestic partnerships and S corporations by allowing them an exception to filing schedules K-2 and K-3 for tax year 2021 if the following conditions are met:

  • In tax year 2021, direct partners in a 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 expect 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) information regarding:
    • Line 16, Form 1065, Schedules K and K-1 (line 14 for Form 1120-S)
    • 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.

Notice 2022-38 further mentions that if a partner/shareholder subsequently notifies the domestic partnership or S corporation that all or part of the information contained on Schedule K-3 is needed for them to complete their tax return, then the partnership or S corporation must provide the requested information. If such information is requested by the partner/shareholder before the partnership or S corporation files its tax return, then the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner/shareholder and also file the same with the IRS.

If your partnership or S corporation does not meet the above criteria, it will still be eligible for penalty relief under Notice 2021-39 if it makes a good-faith effort to adopt the new schedules for the 2021 tax year.