Climbing IRS Schedule K-2 When Preparing Taxes

Located in a remote part of Pakistan, K2 is the earth’s second-highest mountain and the most difficult to climb. Although it’s not as high as Mount Everest, K2 is more dangerous. Many experienced climbers have perished on K2, including 11 on one deadly day in 2008.

There is a cruel irony between the new IRS Schedule K-2 and the similarly named mountain. Granted, it is unlikely that anyone will perish during the preparation of Schedule K-2, Partners’ Distributive Share Items — International. With 19 pages, Schedule K-2 is daunting in its length, even as K2 is daunting in its height. We wish to make Schedule K-2 seem less daunting with this article as we consider a very simple case.

The announcement of Schedules K-2 and K-3 in the summer of 2021 did not raise significant concerns among tax practitioners. The instructions released at that time linked the schedules to the foreign activities of partnerships and S corporations, and it did not seem germane to entities with only domestic income.

The updated instructions dated January 18 carried a different message, however. The IRS added a paragraph indicating that the schedule could still be required if a U.S. partner or shareholder files a tax return having a credit for foreign taxes paid. In this situation, information from a domestic partnership or S corporation could affect the partner’s or shareholder’s Form 1116, Foreign Tax Credit.

The added paragraph threatened an avalanche of small business returns requiring Schedules K-2 and K-3, even though the underlying entity had only U.S.-based income and assets. Given the large numbers of partnerships and S corporations that file returns having only U.S. sourced income and assets, filing and preparing Schedule K-2 and its sibling, Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc. — International, seem like a burden.

A Way Out of Preparing Schedule K-2?

IRS guidance released on February 16 backed off this position only a bit, allowing a partnership or S corporation to avoid filing 2021 Schedules K-2 and K-3 if it is unaware of any partners requesting the information. One safe way of determining this is asking if any partners or shareholders pay enough foreign taxes to have a filing requirement for Form 1116. If none do, then the Schedules are not relevant for 2021.

Under the February 16 guidance, the following conditions create an exception to filing Schedules K-2 and K-3 for 2021 only.[1]

• None of the direct partners in a partnership were foreign partnerships, corporations, individuals, estates, or trusts.
• The partnership or S corporation must have had no foreign activity
• The partnership or S corporation must have paid or accrued no foreign taxes
• The partnership or S corporation must have owned no assets that could have generated foreign-source income.
• The partnership must not have reported any foreign activity in box 16, Part III of its 2020 Schedule K-1, or any activity associated with its Form 1065, Schedule K, line 20c.
• An S corporation must not have reported any foreign activity in box 14, Part III of its 2020 Schedule K-1, or any activity associated with its Form 1120-S, Schedule K, line 17d.
• The partnership or S corporation must be unaware of any partner or shareholder requesting information that would appear on Schedule K-2 or K-3.

For 2022 and beyond, partnerships and S corporations should plan to prepare Schedules K-2 and K-3, even if they do not have to for 2021. Fortunately, most domestic partnerships and S corporations will use less than half of Schedule K-2’s and K-3’s pages. Let’s look at how a domestic partnership would prepare K-2.

An Example Using Schedules K-2 and K-3

Tor, LLC, is a mythical domestic limited liability company with three members, each a U.S. citizen with a one-third interest in all income, expenses, credits, and other tax attributes of the LLC. Tor has only one asset, a piece of unmortgaged rental real estate in the U.S. One member, an individual using the single filing status, paid $500 in foreign taxes, resulting in a Form 1116 filing requirement. This member requests Schedule K-3 information to file their tax return. This case may be the simplest of all scenarios that require Schedules K-2 and K-3, so let’s look at how Tor’s tax practitioner might prepare these schedules.

Schedule K-2 starts by asking for basic information about Tor, LLC. In addition to providing Tor’s name and EIN, we must confirm that it is neither a withholding foreign partnership nor a qualified derivatives dealer. Since Tor only owns real estate in the U.S., the answers to both questions are negative.

Box C presents 12 questions about the partnership, telling the IRS from which parts of the lengthy schedule it needs to capture data. Because Tor only has domestic rental income, only the box for Part II receives a “Yes” answer, and the other 10 checkboxes can be marked “No.”

Part I provides an opportunity to advise the IRS of any of the partnership’s other international information. Tor does not need to mark any of these boxes, as it did not sell any personal property or pay any foreign oil and gas taxes, for example.

Part II reports current year tax information about the rental’s income and expenses. It communicates the following information about Tor LLC to the IRS.

• Gross rental revenue
• Depreciation deduction
• Non-depreciation deductions associated with the real estate
• Deductions associated with the LLC, not the real estate.

In this case, we write “US” on each line to the right of the letter “A” because the income is based in the United States (without periods in “US,” according to the instructions). A loose correlation exists between some line items in Part II of Schedule K-2 and Part III of Schedule K-1, but the instructions provide clearer guidance.

In this example, Tor adds its rental income to the “A” line immediately under “3 Gross rental real estate income” on page 1 of Schedule 2. The amount Tor received as rent during 2021, $36,000, is added to the line in the column labeled “U.S. source.” Because Tor has no income in any foreign jurisdiction, column (g) Total is the only other column on this row that receives a number. Since Tor has no other sources of gross income, no other entries are needed in Schedule K-2 until we get to line 24 at the bottom of page 3.

In line 24, two rows must be completed. To the right of the right-pointing pointer (►), the practitioner enters the sum of all worldwide sources of income. On the line immediately beneath, total U.S. income is entered. Because Tor has only U.S. source income, 36,000 goes on both lines in the (a) and (g) columns.

Section 2 specifies deductions for Tor. If Tor has expenses not associated with the real estate it owns, its tax practitioner lists them on line 25. Assume that Tor pays $50 for its annual franchise tax to its state and $100 in state income tax paid in March 2021 when it filed Form 1065 for 2020. Tor would enter $150 on line 25 at the top of page 4 in columns (a) and (g).

Tor incurs expenses associated with the real estate that are also reported in Section 2. Assume that Tor has $9,000 of depreciation for 2021 and $12,000 in other rental property expenses. $9,000 is entered on line 33, Allocable rental expenses — depreciation, depletion, and amortization, in both columns (a) and (g). Tor must enter $12,000 in columns (a) and (g) for line 34, Allocable rental expenses, other than depreciation, depletion, and amortization.

Total deductions are totaled on line 54, so Tor enters $21,150 ($150 of expenses associated with the LLC + $9,000 of depreciation + $12,000 of other rental expenses). Line 55 reports net income or loss for Tor, LLC, and in this case, $14,850 is entered on line 55 in columns (a) and (g).

Part III need not be completed in this simple example because Tor incurs no interest expense, as its rental property is unmortgaged.

This example is about as simple as it gets, but it illustrates some principles of completing Schedule K-2. Namely, it separates items reported on Schedule K-1 by type of income and source of the income. Of course, a glance through later pages of Schedule K-2 quickly leads to the conclusion that Schedule K-2 can be a challenging climb. It can be complicated by PFIC-sourced income (Passive Foreign Investment Companies) or base erosion and anti-abuse tax under IRC §59A. It can be complicated by the existence of foreign sources of income. But one has to start somewhere, and we hope that this simple introduction to Schedule K-2 makes it seem a little less daunting.

[1] IR-2022-38. Because the way the IRS issued this guidance, it cannot be cited as substantial authority for penalty protection.

By John W. Richmann, EA, MBA
Tax Materials Specialist, U. of I. Tax School