New Schedules K-2 & K-3:
Frequently Asked Questions (FAQs) for S Corporations Filing Form 1120-S

Posted March 4, 2022

Schedule K-2 is a new 14-page form with 7 total parts. It is filed as part of your Form 1120-S, S Corporation Tax Return. It is basically an expansion of Schedule K to provide greater detail on items of international tax relevance from the operation of the S corporation. The Schedule K-2 may also include certain international informational forms, such as Forms 5471, 8858, 926, 8621, and 8992. Many of these forms have a $10,000 penalty for failure to file.

Schedule K-3 is a 15-page form with 7 total parts. Like a Schedule K-1, a Schedule K-3 is provided to each shareholder to provide information on that shareholder’s allocation of pass-through items from the business. In this case, it provides details on that shareholder’s allocation of international items reported on Schedule K-2. It also provides the pass-through data needed for any international informational forms (such as Forms 5471, 8858, 926, 8621, and 8992) that must be filed as part of each shareholder’s Form 1040, Individual Income Tax Return.

Even if S corporations do not have foreign income or foreign assets, they may still need to file Schedules K-2 and K-3.

Formerly, Form 1120-S Schedules K and K-1 did not require any specific format to provide international information. As a result, many details needed for the accurate preparation of shareholders’ individual income tax returns were either lumped together on Schedule K-1, lines 14 and 17d, or missing altogether.

Plus, information on international informational filing requirements (such as IRS Forms 5471, 926, 8992, 8865, and 8621, which carry large penalties) was often referenced in a footnote with unintelligible details and a caveat to “see your tax preparer.”

Per the IRS, this resulted “…in what could be a confusing array of statements attached to the schedules K and K-1. The new schedules K-2 and K-3 provide greater certainty and consistency, helping partners and shareholders to voluntarily comply with their filing and reporting obligations.”

Now, the IRS is requiring the more detailed Schedules K-2 and K-3 to provide this clarity, and it is motivating S corporations and individual shareholders to comply by imposing $10,000 penalties.

Most likely. The IRS’s FAQs on Schedules K-2 and K-3, released in mid-February 2022, clarified that many partnerships and S corporations, including those that do not have foreign assets or operations, may need to file the new forms:

“In many instances, a partnership or S corporation with no foreign partners, 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 or shareholder claims the foreign tax credit, the partner generally needs certain information from the partnership on Schedule K-3, Parts II and III, to complete Form 1116.”

This clarification came as a surprise to many partnerships and S corporations that don’t have foreign items. Given the uncertainty and potential penalties, many of these businesses are taking a conservative approach and are now seeking to understand and file the new schedules.

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:

1. 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.
2. In tax year 2020, the S corporation did not provide to its shareholders—nor did the shareholders request—the information regarding the following:
   1. Line 14, Form 1120-S, Schedules K and K-1, and
   2. 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).
3. 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.

Possibly. If the S corporation has no foreign income, assets, or other international items to report AND all shareholders forego (completely) the claiming of foreign tax credits on their individual returns, then the S corporation could potentially skip the filing of Schedules K-2 and K-3. Again, we would urge caution here, for several reasons:

1. There is a cost to foregoing foreign tax credits on individual tax returns. Depending on the magnitude of a shareholder’s foreign tax credits, he or she may not agree or it may not be worth it to forego the credits.
2. If a shareholder later needs this information, it might need to be produced anyway.
3. A shareholder might inadvertently claim foreign tax credits on their individual return for foreign taxes paid via their US brokerage accounts, thus nullifying the exception.
4. As stated above, it’s not clear whether S corporations may be required to file Schedules K-2 and K-3 even if they do not have foreign income or assets.

If shareholders did want to forego foreign tax credits to avoid filing Schedules K-2 and K-3, they need not completely forego claiming of foreign tax credits on their individual returns. Individuals can elect to claim foreign tax credits without filing Form 1116 if the following conditions are all met:

1. All foreign source gross income was “passive category income.”
2. All the income and any foreign taxes paid on it were reported to the taxpayer on a qualified payee statement (e.g., Form 1099 or 1099-DIV).
3. The total foreign taxes paid are not more than $300 if single or $600 if married filing joint.

That said, we advise the same cautions as above.

The penalty for failing to file or filing an incomplete Schedule K-2 or K-3 is $10,000. This penalty can be applied at both the entity level and the individual shareholder level. The IRS has provided temporary relief for this penalty for 2021 under Notice 2021-39.

In late 2021, the IRS announced that it would not begin accepting Schedules K-2 and K-3 until end of March 2022 at the earliest. Since this timeframe is after the March 15 due date for 2021 Forms 1120-S, the IRS indicated that any S corporations needing to file these schedules should plan to request an extension of time to file.

The IRS is focusing on partnerships first (before individual filers and S corporations with Schedules K-2 and K-3). At this time, S corporation e-filing is not slated until mid-June.

Although the official timeframe for e-filing Schedules K-2 and K-3 is mid-June, the IRS has now provided a workaround to allow S corporations to e-file by the March 15 due date. S corporations can e-file by March 15 if Schedules K-2 and K-3 are included as an attachment to the return (rather than as forms within the return). This method is not typically allowed for e-filing of mandatory tax forms and schedules. In this case, however, the IRS has made a temporary exception.

One caveat: as of February 2022, the IRS was still updating its guidance and filing instructions for the Schedules K-2 and K-3. Also, S corporations and tax practitioners were still seeking additional guidance from the IRS on completion of these forms. Given the ongoing changes and updates, it’s unclear if all details will be sorted by March 15, and some S corporations may benefit from delaying their filings.

Yes. The IRS has released a timeline for accepting e-filed returns with the new Schedules K-2 and K-3. S corporation returns are slated for the middle of the year:

Form Number                                             Date Available

Form 1065, Schedules K-2 and K-3           March 20, 2022

Form 1120-S, Schedules K-2 and K-3        Mid-June 2022

Form 8865, Schedules K-2 and K-3           January 2023

Note that these dates reflect the earliest dates that the IRS will begin accepting the e-filed tax returns. It may take additional time (typically, a few weeks) for these forms to be finalized in tax preparation software.

Fortunately, as indicated above, the IRS has provided a workaround to allow S corporations to e-file earlier, if they so choose. S corporations can file by March 15 if Schedules K-2 and K-3 are included as an attachment to the return (rather than as forms within the return).

While the IRS is working diligently to enable S corporations to file their 2021 returns with the new schedules as soon as possible, guidance on the new forms continues to evolve. Since failure to properly complete or file the new schedules may subject the business and its owners to separate $10,000 penalties, many businesses are taking a conservative approach. As a result, it is likely that individual shareholders will need to file extensions for their personal individual income tax returns this year.

You may also refer them to our Frequently Asked Questions for individuals waiting on K-1s.

We have compiled Frequently Asked Questions for individuals to help explain how the new Schedule K-2 and K-3 will affect their individual tax filings. These explanations can be shared with any shareholders to help address their questions.

If you typically receive Schedules K-1 from partnerships and you are expecting Schedules K-3 this year, then you will generally need to wait for them before you can file your S corporation return.

If you are expecting a 2021 Schedule K-3 but do not receive it, then you may need to disclose this on your Form 1120-S to protect yourself against the $10,000 penalty. IRS FAQ 16 indicates that a Form 8082, Notice of Inconsistent Treatment, may need to be filed to alert the IRS of the missing Schedule K-3.

At the time of this blog post, the IRS was still making changes to its approach to Schedules K-2 and K-3 in response to push-back from tax professionals and other parties. In particular, the American Institute of Certified Public Accountants (AICPA) and other organizations were encouraging the IRS to delay the new Schedule K-2 and K-3 filing requirements, offer greater relief for 2021 filings, or otherwise waive first-year penalties.

We expect that the IRS’s requirements and guidance will continue to evolve over the coming weeks.

At The Wolf Group, we are monitoring these developments and continuing to evaluate the approaches that are in the best interest of our clients. If you have questions on the new Schedules K-2 and K-3 or need assistance complying with the additional foreign reporting, please contact us. The Wolf Group has assisted clients with foreign disclosures and related tax form preparation for nearly four decades.