In a statement issued late yesterday the IRS indicated that it heard the tax industry’s concerns about new reporting requirements for pass-through entity (PTE) returns and would be issuing further guidance soon. That guidance came early today in the form of a new FAQ.
The FAQ (Question 13) discusses the January 18, 2022 update to the Schedule K2/K3 instructions that was the source of confusion, confusion that at times bordered on panic, in the tax community. The FAQ notes that these late updates “provided clarification and exceptions to completing the Schedules K-2 and K-3” and that the late updates came in response to public comments. “The changes generally clarify that domestic partnerships that have solely domestic activities, and have less-than-10% limited U.S. citizen and U.S. resident individual partners are excepted from filing certain portions [emphasis added] of Schedules K-2 and K-3” and that “The updates reduce the requirement to attach certain forms to Schedule K-3.”
Question 15 discusses new relief that is available in addition to the transitional penalty relief provided by Notice 2021-39. To qualify for this exception, four criteria must be met including the following:
- For tax year 2021 no direct partners can be foreign individuals or entities;
- The PTE has no foreign activity (including foreign income, ownership of foreign assets that did or could generate income, or foreign taxes paid) for tax year 2021); and
- The domestic partnership or S corporation has no knowledge that the partners or shareholders are requesting such information for tax year 2021.
It’s that last item that continues to frustrate those preparing PTE returns. For the smallest PTEs it may be possible (with some additional work) to determine whether or not a shareholder will be requesting the K2/K3 information. For larger PTEs determining if an individual shareholder or partner may need the information simply isn’t practical. What can be gleaned from the guidance is that in the absence of knowledge that the information will be needed by a partner or shareholder, the PTE return preparer can, if the entity meets the other requirements, leave Schedules K2 and K3 off of the PTE return (at least for this year). Nevertheless, depending on the entity, the preparer should be prepared to provide the K2/K3 information if requested by a partner or shareholder. The FAQ is also clear that if the preparer has prior knowledge (i.e., knows before the PTE return is filed) that a shareholder or a partner will need the information provided on Schedules K2 and K3 that relief is not available and the new schedules must be included with the PTE return.
What is also clear from reading the FAQ is that the IRS is not fully walking back the K2/K3 reporting requirement for any subset of PTEs (e.g., small businesses or businesses with a limited number of partners or shareholders)—at least not at this time. The new schedules were designed to provide a place to report additional detail that has always been reported (or should have been being reported) on Schedule K1. Nevertheless, the additional relief granted by the FAQ, however temporary, is still welcome. The new relief measures will definitely preclude a large amount of unnecessary reporting for many of the smallest PTE returns. The relief will also allow those tax professionals who were unaware of the requirement or who, until the mid-January clarification, assumed that the new schedules would not be required for the PTEs they prepared, time to get educated on the mechanics of the new reporting.