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The issue of foreign tax reporting has been in flux for the last few years. For the 2021 tax year, the IRS hastily published regulations without warning, that made it onerous for many passthrough entities, and created more complexity and paperwork than many believe was necessary. These were the K-2 and K-3 schedules, which run about 20 pages per owner, and which many of you might have noticed when you received your 2021 K-1’s from S-Corps or Partnerships.
The goal of these schedules was to provide information on the portion of the income from the S-Corp or Partnership related to foreign activities. However, the implementation by the IRS was heavy-handed and made the process complex which added time and cost to the income tax preparation process.
For the current year, the IRS has bowed to pressure and has provided two exemptions that give relief to most passthrough entities with little or no foreign activity. While in theory, this is good news, the qualifications to utilize the exemption are complicated.
To qualify, passthrough entities must only have direct partners and shareholders who are U.S. citizens, resident aliens, or certain domestic estates and trusts, and any foreign activity is limited to less than $300 of foreign taxes paid or accrued. If these definitions are met, then an election can be made to exclude the K-2 and K-3 schedules.
This is where things get a little convoluted. Before the passthrough entity can file the return with this election, they must provide each owner a K-1 with a disclosure that K-3 will only be provided if the owner specifically requests it. The owner has up to one month before the return is filed to request a K-3. If this is the case, one owner can cause the S-Corp or Partnership to file the return with K-2 and K-3s, and the owner who requested the K-3 will receive it with their K-1. This can hold up filing the S-Corp and Partnership return to much later, causing all owners to file their individual returns later than desired.
Another exemption to the K-2 and K-3 filing requirements is if all owners qualify for the Form 1116 exemption. If so, the S-Corp or Partnership doesn’t have to file K-2 or K-3.
Form 1116 reports foreign income and foreign taxes paid on the individual income tax return. The exemption from filing this form is if an individual receives less than $600 ($300 for single filers). By doing so, the individual return is more simplified. However, it disallows any foreign taxes carried over to be utilized.
This exemption will likely be less often utilized because it requires every owner to disclose their intent and qualification for Form 1116 exemption to the S-Corp or Partnership. In addition, the time frame for notifying the S-Corp or Partnership is much shorter than the first exemption; owners were required to disclose their intention by February 15 of the current year for 2022 tax returns, a month before the S-Corp or Partnership’s unextended due date.
At CK, we are working with our clients directly to ensure that the exceptions to filing the K-2 and K-3 schedules are reviewed and disclosed appropriately. If you have questions about these exemptions and if they apply to your S-Corp, Partnership, or your individual return, please call Cray Kaiser today at 630-953-4900.