New foreign reporting requirements for domestic entities

The IRS dropped a bombshell late last week when it revised its Form 1065 and 1120S instructions to state that even domestic partnerships and S corporations with no foreign activities or foreign partners may have to complete and file the new Schedule K-2 (Form 1065), Partners’ Distributive Share Items — International, and Schedule K-3 (Form 1065), Partners’ Share of Income, Deductions, Credits, etc. — International, and the corresponding S corporation schedules.

The problem centers around entities with partners or shareholders who complete Form 1116, Foreign Tax Credit. In order to accurately complete Form 1116, taxpayers will need information from all entities in which they have an ownership interest, even if the entity has no foreign activities. This is why the IRS has expanded the Schedule K-2 and Schedule K-3 filing requirements to ensure that partners/S corporation shareholders who complete Form 1116 will have all the required information.

We are currently in the process of drafting detailed information on these new requirements, but here is our initial take:

  • If you are completing returns for both the partnership or S corporation and all owners and have direct knowledge that none of the owners will be completing a Form 1116 and have no other foreign tax issues, go ahead and file without completing Schedules K-2 and K-3;
  • If you don’t have direct knowledge that none of the owners will be filing Form 1116, you have two options:
    • Put these returns on hold until we get more complete guidance, because failing to file Schedules K-2 and K-3 can result in significant penalties being imposed; or
    • Complete Schedules K-2 and K-3 for these entities, providing the minimal amount of information required. Though these forms are massive, when there is no foreign activity it appears it does not take much time to complete the required information.

To further complicate this issue, the IRS is not currently accepting e-filing of Schedule K-2 or Schedule K-3. However, you can currently attach these forms as PDFs to e-filed returns.

Want more on Schedules K-2 and K-3? We will be covering them in more detail, including what information needs to be provided, in the next issue of Spidell’s Federal Taxletter and at Spidell’s 2022 Post-Tax Season Update and Review webinar.