On April 11, 2022, the IRS expanded its page of frequently asked questions with regard to Schedules K-2 and K-3 from 18 questions and answers to 26.[1] While this falls far short of covering all of the questions many have remaining with regard to completing these forms, it does provide some additional guidance.

Not Required to Complete Irrelevant Parts of Schedules K-2 and K-3

The first new question looks at the issue of whether all parts of Schedules K-2 and K-3 must be completed if a taxpayer is required to complete those forms for any reason. The question and answer read:

19. The partnership or S corporation does not qualify for the exception in FAQ #15. Is the partnership or S corporation required to complete all parts of Schedules K-2 and K-3? (added April 11, 2022)

According to page 1 of the Instructions to Schedules K-2 and K-3 (Form 1065) and page 1 of the Instructions to Schedules K-2 and K-3 (Form 1120-S), a partnership and S corporation are only required to complete the relevant portions of Schedules K-2 and K-3. See FAQ #17 for a link to the instructions.[2]

Cases With an Exception to Completing Forms 5471, 8865 and/or 8858

The next question looks at the case where a taxpayer meets an exception that means it is not required to file Forms 5471, 8865 and/or 8858. The page provides:

20. A filer otherwise required to file Forms 5471, 8865, and/or 8858 may qualify for an exception from filing those forms based on the Internal Revenue Code, IRS guidance, and/or instructions to those respective forms (for example, the multiple filer exception). If the filer qualifies for such exception, do the Instructions to the Schedules K-2 and K-3 nevertheless require a filer to complete Forms 5471, 8865, and/or 8858? (added April 11, 2022)

No. If the filer meets such an exception to filing Forms 5471, 8865, and/or 8858, the filer is not required to complete and attach those forms. However, the filer must still attach to the Forms 1065, 1120-S, and the tax return of the U.S. person filing Form 8865, any required statements to qualify for the exception to filing the Forms 5471, 8865, and/or 8858. Further, in the case of the Form 5471 multiple filer exception, the partnership or S corporation must provide on the Schedule K-3 to its partners or shareholders any information that the partnership or S corporation receives from the person required to file the Form 5471 and that is requested by the Instructions to the Schedules K-2 and K-3, such as Schedule Q (Form 5471) information, if applicable.[3]

Use of the “RIC” Code for Mutual Fund Foreign Income Source

The unanswered question I received inquiries on most often during tax season from practitioners related to how to report the source of income received from mutual funds that also reported foreign taxes eligible for the foreign tax credit. Such funds are not required to report to their shareholders the detailed sourcing of the income by country. The instructions for individual Form 1116 provide that taxpayers can treat all such income from mutual funds as from a single source referred to with the code RIC.

The IRS’s original guidance indicated that one of the two letter country codes from their webpage had to be used to designate the source of all foreign income. A number of professional tax software providers took that statement literally and did not allow designating income on Schedules K-2 or K-3 as being sourced using that three letter code. However, the expanded FAQ provides that the RIC (registered investment company) code can be used.

21. In Part II, Section 1 (Description) and Part III, Section 4, Lines 1 and 3 of Schedules K-2 and K-3 (Forms 1065, 1120-S, and 8865), is it possible to enter the code “RIC”? (added April 11, 2022)

Yes, page 8 of the Instructions to the Schedules K-2 and K-3 (Form 1065) refers to the Instructions to Forms 1116 and 1118 for exceptions from the requirement to report gross income and taxes by foreign country or U.S. possession, including for regulated investment companies. See also page 8 of the Instructions to the Schedules K-2 and K-3 (Form 1120-S) and page 7 of the Instructions to the Schedules K-2 and K-3 (Form 8865). See FAQ #17 for a link to the instructions.[4]

When the R&E Expenses Apportionment Factors of Part III, Section 1 Must Be Completed

The updated FAQ also provides relief from taxpayers having to provide detailed R&E expense apportionment factors in most cases.

22. When must a filer complete Section 1 of Part III, Schedules K-2 and K-3 (Forms 1065, 1120-S, and 8865)? (added April 11, 2022)

A filer is not required to complete Section 1 of Part III unless either (1) the partnership or S corporation incurs research & experimental expense or (2) the partner or shareholder is expected to license, sell, or transfer its intangible property to the partnership or S corporation (as provided in §1.861-17(f)(3)). This clarification will be added to the tax year 2022 instructions. However, filers may choose to follow this clarification for tax year 2021.[5]

Passive Foreign Investment Company Issues

Question 23 deals with issues related to Passive Foreign Investment Companies.

23. If a foreign partnership has passive foreign investment companies (PFICs) for which a mark-to-market (MTM) election described in Treas. Reg. §1.1291-1(c)(4) has been made (for example, under section 475), does the filer need to report the PFICs on Part VII of Schedules K2 and K3 (Forms 1065 and 8865)? (added April 11, 2022)

No, if a foreign partnership marks to market stock of a PFIC as described in Treas. Reg. §1.1291-1(c)(4), the filer of Form 1065 does not need to report information about the PFIC on Part VII. The filer should report the partnership’s MTM gain or loss on Schedule K (Form 1065) and report the partners’ shares of such amounts on Part III of Schedule K-1 (Form 1065). Similarly, a U.S. person filing Form 8865 with respect to a foreign partnership that has made an MTM election described in Treas. Reg. §1.1291-1(c)(4) for a PFIC should report the partnership’s MTM gain or loss on Schedule K (Form 8865) and report the partners’ share of such amounts on Part III of Schedule K-1 (Form 8865).

There may, however, be instances in which the partner will need additional information from the partnership to meet its tax obligations with respect to the PFIC, such as when section 1291 rules apply because the stock was not marked in the first year of the holding period. In such instances, the partnership should provide the needed information and may use Part VII to do so.[6]

Reporting for Dormant Foreign Corporations

The next question deals with reporting for dormant foreign corporations as defined in section 3 of Revenue Procedure 92-70:

24. Are Part VIII (Form 1065) and Part VII (1120-S) of Schedules K-2 and K-3 required to be completed for dormant foreign corporations (as defined in section 3 of Rev. Proc. 92-70)? (added April 11, 2022)

No, Part VIII (Form 1065) and Part VII (Form 1120-S) are not required to be completed with respect to dormant foreign corporations. This clarification will be added to the tax year 2022 instructions. However, filers may follow this clarification for tax year 2021.[7]

Reporting Accrued Original Issue Discount and OID Income Taxable to a Foreign Partner

The longest answer added to the page relates to the reporting to a foreign partner of accrued original issue discount and OID income taxable on a gross basis to a foreign partner.

25. How should a partnership report its accrued original issue discount (OID) and OID income taxable on a gross basis to a foreign partner on Section 1 of Part X of Schedules K-2 and K-3 (Form 1065)? (added April 11, 2022)

The following approach is solely a recommendation for tax year 2021, and the IRS recognizes that partnerships may have taken other approaches. The IRS appreciates comments on this approach and whether there are other approaches to reporting OID on Part X of Schedules K-2 and K-3. The IRS will take these comments into account for the tax year 2022 Instructions to the Schedules K-2 and K-3.

A partnership generally reports OID on Schedules K and K-1 (Form 1065) in the taxable year the OID accrues. However, the instructions to Part X of Schedules K-2 and K-3 (Form 1065) require the partnership to report OID only when it is taxable to foreign partners (i.e., when there is a payment or gain on the OID instrument). To reconcile Schedules K-2 and K-3 reporting of OID with Schedules K and K-1 reporting of OID and to provide foreign partners with the information necessary to complete their returns, the IRS recommends the following approach for reporting OID on Part X.

Accrued OID Reported on Form 1065

The amount of accrued OID reported on Schedules K (Form 1065) which is not taxable to foreign partners should be reported as interest income in column (f) (U.S. source (other)) of Part X, Schedule K-2. The IRS recommends that the partnership attach a statement to Form 1065 with respect to Part X clarifying that these amounts are not taxable to foreign partners and need not be reported on the foreign partner’s tax return. The partnership should take a similar approach for reporting distributive share amounts to a foreign partner on Schedule K-3.

OID Payments or Gains Taxable on a Gross Basis to a Foreign Partner

When the partnership receives payments on the OID instrument or gain on the sale or exchange of the OID instrument that are taxable on a gross basis to foreign partners, these amounts should be reported in column (e) (U.S. source (fixed, determinable, annual, or periodical - FDAP)) as interest income or gain, as appropriate. These amounts should also be entered as a negative adjustment in column (f) to ensure that the total OID reported on Part X reconciles with OID reported on Schedule K (Form 1065). Additionally, the IRS recommends attaching a statement explaining that the negative adjustment in column (f) is for reconciliation purposes only and is not relevant to the foreign partner’s tax liability and therefore need not be reported on the foreign partner’s tax return. The partnership should take a similar approach for reporting distributive share amounts to a foreign partner on Schedule K-3.

Example

In addition to other income and expense items, a partnership accrues $100 OID in year 1 reported on Schedule K (Form 1065). On Part X of Schedule K-2 for year 1, the partnership should report this amount as interest in column (f) (such amount is also included in column (a) for the total). In year 2, the partnership receives a payment with respect to the same instrument that results in $50 of gross income taxable on a gross basis to its foreign partners. On its Part X of Schedule K-2 for year 2, the partnership should report $50 as interest in column (e) and ($50) as a reconciliation adjustment in column (f). The partnership should take the same approach for reporting distributive share amounts to a foreign partner on Schedule K-3 in both years 1 and 2.[8]

Clarification for Reporting of Allocation and Apportionment Methods for Deductions

The IRS concludes the new additions to the FAQ by giving additional guidance on completing Section 3 of Part X, Schedules K-2 and K-3 (Form 1065).

26. Could you clarify the reporting on Section 3, Lines 2b, 3a, and 3b, of Part X, Schedules K-2 and K-3 (Form 1065)? (added April 11, 2022)

The tax year 2022 instructions will clarify the reporting on Section 3, lines 2b, 3a, and 3b of Part X, Schedules K-2 and K-3 (Form 1065) as follows:

Line 2b. Average worldwide assets. Report the partnership’s basis in its average worldwide assets for purposes of Treasury Regulation section 1.882-5(b) using the average amount as defined in Treasury Regulation sections 1.882-5(b)(3) and 1.884-1(d)(3)(ii).
Line 3a. Average U.S.-booked liabilities of the partnership. Enter the partnership's average U.S.-booked liabilities as defined in Treasury Regulation section 1.882-5(d)(2) using the average defined in Treasury Regulation section 1.882-5(d)(3).
Line 3b. Directly allocated partnership indebtedness. Enter the portion of the principal amount of the partnership’s indebtedness outstanding at year end that meets the requirements of Temporary Regulation section 1.861-10T(b) or (c), as limited by Temporary Regulation section 1.861-10T(d)(1), as described in Treasury Regulation section 1.882-5(a)(1)(ii)(B). See Treasury Regulation section 1.861-10T(d)(2).

A partnership may choose to follow the above instructions for tax year 2021 Schedules K-2 and K-3 (1065).[9]

[1] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022, https://www.irs.gov/businesses/schedules-k-2-and-k-3-frequently-asked-questions-forms-1065-1120s-and-8865 (retrieved April 20, 2022)

[2] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[3] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[4] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[5] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[6] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[7] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[8] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022

[9] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), April 11, 2022 update, IRS website, April 11, 2022