Tax professionals who prepare returns for pass-through entities (PTEs), Partnerships and Subchapter S Corporations (S-corps) know that for tax year 2021 two new information reporting forms (Forms K2 and K3) may be required for PTEs with foreign partners or shareholders. According to Bruce Friedland, IRS Media Relations, “The schedules K-2 and K-3 replace already required reporting that in practice – when it has been done – is part of attached statements, to returns and footnotes to Schedule K-1. While the schedules clarify information a partner or flow-through investor would need to complete their taxes accurately to take into account international items, the schedules do not ask for additional information [emphasis added]. Instead, the schedules are intended to improve reporting in a way that will be more useful for partners or flow-through investors, and over the longer term ease flow-through return preparation compliance by clarifying obligations and standardizing the format for reporting.” Friedland also noted that, “To ensure the public had the opportunity to provide input on the new schedules, the IRS took the unusual step of issuing the draft Schedule K-2 and K-3 in July 2020 and held events with external stakeholders shortly after the release to seek input and feedback. The comments received through all channels informed the revisions to the form, an early version of which was released in April 2021.” Final forms and draft instructions were then released in June 2021.
Many tax professionals after reviewing the IRS information releases and the draft forms and instructions decided, probably correctly, that the new requirements did not apply to the PTE returns they typically prepare and proceeded to focus on more immediate concerns. Indeed, according to Tom Gorczynski, Enrolled Agent, “Until recently it was believed this new, complex reporting requirement was limited to PTEs with international tax attributes.” But a recent update to the instructions for these schedules has tax professionals who prepare PTE returns in an uproar and believing (probably correctly) that the reporting requirement applies to a much larger percentage of PTE returns than perhaps the IRS intended. The revision was not included in the draft or published instructions for Schedules K-2 and K-3 but was added on January 18, 2022 to an IRS web page and states:
“A partnership with no foreign source income, no assets generating foreign source income, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner claims a credit for foreign taxes paid by the partner, the partner may need certain information from the partnership to complete Form 1116.” Note that while the quoted instruction applies to partnership returns a similar provision was added to the instructions for S-corporation returns.
According to Gorczynski (and many other tax professionals) “A plain reading of the text indicates that a PTE with absolutely zero foreign activities may still need to file Schedules K-2 and K-3 if any of the owners will file Form 1116, Foreign Tax Credit” because some of the entity’s data may affect the calculation of the foreign tax credit limitation on the shareholder or partner’s Form 1040. Gorczynski adds “This seems like an overly burdensome requirement to quietly clarify in the middle of filing season.”
Tax professionals are concerned because the most prudent course of action appears to be to file the new schedules for all PTE returns just in case any partner or shareholder will be filing a Form 1116 with their annual Form 1040. The new schedules will not be available for e-filing until March 20, 2022 for Form 1065 and mid-June 2022 for Form 1120-S. The un-extended deadline for PTE returns is March 15, 2022. Tax professionals who intend to file these schedules for all PTE returns have two alternatives. If they do not want to file an extension for the return they can, if their software permits it, attach the schedules in PDF format to an electronically filed return.
The other option is to put the return on extension and wait until the new schedules are available for e-filing. Additionally, because so many tax preparers originally considered the new schedules as a matter of interest only for partnerships with foreign tax attributes, they did not devote a large amount of bandwidth to learning about the associated filing requirements. Consequently, many are planning on putting all of their PTE returns on extension while they get up to speed on the new rules. These alternatives, while prudent, present some potentially serious unintended consequences:
- The IRS may be inundated with PDF attachments that it is not prepared to process and review. PDF attachments are often separated from original returns never to be seen again—at least not until the taxpayer receives a notice looking for the “missing” information.
- Many more PTE returns may be put on extension than would normally be the case.
- Extended PTE returns mean extended 1040s, which is unsatisfactory to many taxpayers and tax professionals.
CPA Fred Stein is concerned but is also hoping calmer heads prevail. “This just stinks of the 3115 scenario way back.” Way back in 2016 (which is starting to seem like a lifetime ago for many tax professionals) the IRS changed the filing requirements for Form 3115, Application for Change in Accounting Method, and after a plain reading of the instructions the tax community concluded that millions of new Forms 3115 would have to be filed. Reacting to the tax community’s concern, the IRS applied Occam’s Razor and clarified the filing requirement to better capture the intent of the new rules and to provide for a simplified filing requirement for some of the most common scenarios. Similarly, Stein is hoping Occam’s Razor again “kicks in and IRS realizes the unintended consequences this creates for many small businesses.” If not, the additional work involved could cause PTE return preparation prices to increase by thirty to fifty percent.
For example, Matthew Smith, a CPA in Manhattan Beach, California, recently stated that the easiest Form 1065 he files went from 16 to 45 pages because of the new requirements. The partnership in question has “a bank account with one transaction” (payment to him for filing the prior year’s 1065) and two 50-50 partners. Nothing else. Nothing else other than both partners are usually required to file Form 1116. Form 1116 is required when claiming a foreign tax credit over $300 for single filers ($600 for joint filers), even when all foreign tax paid is reported on a third-party information return (such as a Form 1099-B for an investment account). Indeed, it would seem that what was supposed to be a targeted and technical reporting requirement will now be applied to many more PTE returns than the IRS originally intended. Friedland noted that “The IRS knows these changes can cause short-term challenges, especially for flow-through entities and their preparers. We issued Notice 2021-39, which provides penalty relief for good faith efforts to adopt the new schedules.”
While transitional penalty relief is welcome, it will typically come in the form of response to a penalty notice which, according to Notice 2021-39, requires the taxpayer to establish “to the satisfaction of the Commissioner” a good faith effort to comply with the requirements. In other words, manual review of the request for penalty abatement rather than automatic relief for anyone who requests it. Many tax professionals on social media have noted that, while they understand that the new requirements are an important part of closing the part of the tax gap related to foreign tax reporting, perhaps the IRS should be focused on clearing the existing backlog of unprocessed returns, amended returns, and notice responses before implementing a new requirement that could possibly generate an avalanche of new notices (and unprocessed responses).
Steve Helmuth, a Nashville CPA, thinks the IRS missed a simple safe harbor opportunity. He feels that, at least at the outset, the IRS could have applied the new requirement to only those PTEs above the small business gross receipts threshold of $25M. Providing the safe harbor would allow the IRS to focus on the largest businesses, with arguably the most resources available for meeting the new requirement, while working out the kinks. Once the new reporting requirement was refined with respect to the necessary administrative burdens and determined to be beneficial its applicability could be extended to additional PTEs.
Smith also sees a missed opportunity and some really bad optics for the IRS. He notes that “Tax practitioners have noticed that Box 16 (Form 1065, Schedule K-1) and Box 14 (Form 1120-S, Schedule K-1) were getting increasingly cluttered in recent years to reflect the increased complexity of foreign reporting following the passage of the Tax Cuts and Jobs Act (TCJA). The IRS could have used this as an opportunity to separate out the largely nonapplicable reporting information targeted at entities with multinational involvement from the relatively simple foreign tax credit information that is routinely incorporated into taxpayers’ returns. This approach would have undoubtedly been embraced and have had a positive impact on compliance across the spectrum. Instead, the IRS leveled a massive compliance burden on small business PTEs while further convoluting the information being reported to partners and shareholders.”
In the meantime much of the tax community is focused on addressing the requirement for PTE returns with a small number of partners or shareholders and no foreign tax attributes while others, if tax-centric groups on social media are to be believed, are completely unaware of the new requirements and how they could affect not only their PTE returns but also their 1040s. When a practitioner can determine with certainty that no Forms 1116 will be filed for partners or shareholders, the new reporting can be avoided for the PTE return. For example, although it is less beneficial in terms of tax paid, choosing to deduct foreign taxes paid on Schedule A, Itemized Deductions, avoids the need for filing a Form 1116. If the practitioner preparing the PTE return can ensure that all partners or shareholders do not have a foreign tax credit; that the credit (if present) is exempt from the Form 1116 requirements because it is below the dollar threshold and reported on a third-party information return; and/or that individuals who would normally have to file a Form 1116 will elect to deduct the foreign tax paid on a Schedule A or simply forego claiming the credit (neither of which is a taxpayer friendly solution) then the practitioner can eliminate the need to file Schedules K-2 and K-3 for the entity.
Return preparers may decide to put some of this additional work back onto the responsible partner or shareholder by tasking them with providing Forms W9 for partners and shareholders, ensuring that partners and shareholders understand the new requirements, and confirming for the practitioner (possibly in writing) that all partners and shareholders do not have a Form 1116 obligation. Unfortunately many individuals don’t know if they file Form 1116 or won’t know until their Form 1040 has been prepared because the Form 1116 filing requirement depends on taxes paid on foreign investments in their brokerage accounts. Many will not understand why their tax professionals are asking all of these additional questions about foreign tax paid and Form 1116 and why they may be told to expect to go on extension until this matter gets resolved. Many others will have return preparers who are, quite simply, not aware of the new requirement which could cause incorrect calculations on Form 1116 (and possibly associated notices).
As of this writing it was unclear whether or not the IRS is aware of the potential avalanche of PDF attachments, extended returns, and other unintended consequences. They may, however, be more aware today than they were yesterday. Yesterday a group of Senators sent a letter to Treasury Secretary Yellen and Commissioner Rettig requesting additional relief for taxpayers including asking the Commissioner to “Consider modifying the current implementation of Schedules K-2 and K-3 to focus on clearing the backlog instead of adding more complexity.” Presently, the situation bears more waiting to give the IRS a bit more time to address the issue (and possibly walk back or clarify the requirements). Nevertheless, the deadline for PTE returns is looming so if the IRS is going to issue additional guidance or clarification they need to do it soon.