While there are exceptions, we advise you to tread carefully. The exceptions are much more limited than expected. And failure to file Schedules K-2 and K-3 carries $10,000 penalties.
As of late February 2022, the IRS continued to release new guidance and FAQs on Schedules K-2 and K-3. As it did so, it provided much needed clarifications on how the new forms must be completed and by whom.
The IRS specifically addressed multiple questions about whether S corporations without foreign assets or income needed to file Schedules K-2 and K-3. In most cases, the answer was yes. It did provide a narrow exception under FAQ 15.
IRS FAQ 15 indicates that S corporations need not file Schedules K-2 and K-3 if all of the following conditions are met:
- In tax year 2021, the S corporation had no foreign activity, including foreign taxes paid or accrued or ownership of assets that generate, have generated, or may reasonably expected to generate foreign source income.
- In tax year 2020, the S corporation did not provide to its shareholders—nor did the shareholders request—the information regarding the following:
- Line 14, Form 1120-S, Schedules K and K-1, and
- Line 17d, Form 1120-S, Schedules K and K-1 (Controlled Foreign Corporations, Passive Foreign Investment Companies, 1120-F, §250, §864(c)(8), §721(c) partnerships, and §7874).
- The S corporation has no knowledge that the shareholders are requesting such information for tax year 2021.
This last condition is the most problematic to prove, especially if the individual shareholders file Form 1116 (Foreign Tax Credits) on their personal returns. If the shareholders with responsibility for preparing and signing the Form 1120-S for the S corporation are aware that any shareholder files Form 1116 on their personal return, then it may be difficult to argue that this condition is met.
FAQ 15 also states:
“…if the partnership or S corporation is subsequently notified by a partner or shareholder that all or part of the information contained on Schedule K-3 is needed to complete their tax return, then the partnership or S corporation must provide the information to the partner or shareholder. If a partner or shareholder notifies the partnership or S corporation before the partnership or S corporation files its return, the conditions for the exception are not met and the partnership or S corporation must provide the Schedule K-3 to the partner or shareholder and file the Schedules K-2 and K-3 with the IRS.”
So, if a shareholder requests the Schedule K-3 reporting for their individual Form 1116, then the S corporation would need to provide it for that shareholder. For practical purposes, the S corporation would provide it for all shareholders as it would be unknown if and when other shareholders might make this request.
Also, if the request is made before the Form 1120-S S corporation tax return is filed, then the exception is not met, and the S corporation must produce Schedules K-2, as well as Schedules K-3 for all shareholders.
Another consideration is that another IRS FAQ (#11) may contradict and override FAQ 15. Thus, an argument could be made that FAQ 11 requires Schedule K-2 and K-3 reporting no matter what.
Furthermore, the IRS FAQs cannot be relied upon for relief. Since the FAQs haven’t been published in the IRS Internal Revenue Bulletin, they don’t carry much weight and do not constitute “substantive authority” from a legal perspective. That means that S corporations can use them to get an idea of what the IRS is thinking but cannot point to them as an official reason for not filing Schedules K-2 and K-3. On October 15, 2021, the IRS released the following:
“Notwithstanding the non-precedential nature of FAQs, a taxpayer’s reasonable reliance on an FAQ (even one that is subsequently updated or modified) is relevant and will be considered in determining whether certain penalties apply. Taxpayers who show that they relied in good faith on an FAQ and that their reliance was reasonable based on all the facts and circumstances will have a valid reasonable cause defense and will not be subject to a negligence penalty or other accuracy-related penalty to the extent that reliance results in an underpayment of tax.”
However, this relief does not apply to international informational penalties, such as the $10,000 penalty for non- or mis-reporting Schedule K-2 and K-3 information.
Given the evolving IRS guidance, very limited exceptions, and high penalties, many S corporations are taking a conservative approach and preparing Schedules K-2 and K-3 for 2021.