TAX ALERT  |  July 14, 2021

On June 30, 2021, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) dropped draft instructions for Schedules K-2 and K-3 for Forms 1065, 1120-S and 8865 for tax year 2021 (filed in 2022). New Schedules K-2 and K-3 were released earlier in June and aim to provide a standardized format for reporting U.S. international tax information to the partners and shareholders of pass-through entities, replacing the K-1 footnotes, whitepaper disclosures and pro-forma forms (which may be vague, inconsistent and confusing) currently used by these entities to report such information. 

Treasury and the IRS also issued on June 30, 2021, Notice 2021-39. The Notice announces transition relief from penalties for incorrect or incomplete reporting on the Schedules K-2 and K-3 for taxable years that begin in 2021. Relief will be granted if the filer establishes to the satisfaction of the Commissioner that it made a good faith effort to comply with the Schedules K-2 and K-3 filing requirements (and the Schedule K-3 furnishing requirements) per the instructions. 

Missing from the draft instructions and Notice is much needed guidance on the interaction of the CFC rules and the rules in Subchapters K and S, including—

• Whether a domestic partnership or S corporation is required to track the individual previously taxed earnings and profits (PTEP) accounts or CFC stock basis adjustments of its partners or shareholders;
• Whether a domestic partnership or S corporation may increase its basis in its CFC stock to the extent that a partner or shareholder is entitled to a basis increase in their partnership or S corporation interest under section 961(a);
• The treatment of distributions of PTEP from a CFC to a domestic partnership or S corporation; and 
• The treatment of gain recast as dividend income under section 1248 following the sale of a CFC by a domestic partnership or S corporation.

Takeaway

New Schedules K-2 and K-3 are quite lengthy, detailed and complex and may create an increased tax compliance burden, though much of the information reported on these new schedules should be information that has historically been calculated and reported on K-1 footnotes, whitepaper disclosures or pro-forma forms.