In Notice 2021-39,[1] issued at the same time as draft versions of the 2021 instructions for new Forms K-2 and K-3 for partnerships and S corporations, the IRS provided limited relief from penalties related to issues properly preparing those forms on 2021 tax returns.

The Notice describes the new forms as follows:

Form 1065, Schedules K-2, Partners’ Distributive Share Items — International, and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International, are new for taxable years beginning in 2021. These schedules replace, supplement, and clarify the reporting of certain amounts formerly reported on Form 1065, Schedule K, Partners’ Distributive Share Items, line 16, Foreign Transactions, and Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., Part III, Partner’s Share of Current Year Income, Deductions, Credits, and Other Items, line 16, Foreign Transactions. Schedules K-2 and K-3 also replace, supplement, and clarify reporting of certain amounts formerly reported on Form 1065, Schedule K, line 20c, Other items and amounts, and Schedule K-1 (Form 1065), Part III, line 20, Other information. The new standardized format assists partnerships in providing partners with the information necessary to complete their returns with respect to the international tax aspects of the Code and allows the IRS to more efficiently verify tax compliance.

For the same reasons, for taxable years beginning in 2021, Form 1120-S includes new Schedules K-2, Shareholders’ Pro Rata Share Items — International, and K-3, Shareholder’s Share of Income, Deductions, Credits, etc. — International. These schedules replace, supplement, and clarify the reporting of certain amounts formerly reported on line 14, Foreign Transactions, of both Form 1120-S, Schedule K, Shareholders’ Pro Rata Share Items, and Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc. Part III, Shareholder’s Share of Current Year Income, Deductions, Credits, etc. Schedules K-2 and K-3 also replace, supplement, and clarify the reporting of certain amounts formerly reported on Form 1120-S, Schedule K, line 17d, Other items and amounts, and Schedule K-1 (Form 1120-S), Part III, line 17, Other Information.

Finally, for the same reasons, for taxable years beginning in 2021, Form 8865 includes new Schedules K-2, Partners’ Distributive Share Items — International, and K-3, Partner’s Share of Income, Deductions, Credits, etc. — International. These schedules replace, supplement, and clarify the reporting of certain amounts formerly reported on line 16, Foreign Transactions, of both Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, Schedule K, Partners’ Distributive Share Items, and Schedule K-1 (Form 8865), Partner’s Share of Income, Deductions, Credits, etc., Part III, Partner’s Share of Current Year Income, Deductions, Credits, and Other Items. Schedules K-2 and K-3 also replace, supplement, and clarify the reporting of certain amounts formerly reported on Form 8865, Schedule K, line 20c, Other items and amounts, and Schedule K-1 (Form 8865), Part III, line 20, Other information.[2]

Penalties Covered by the Relief

As the Notice describes, a failure to properly prepare and issue these forms for the applicable 2021 tax returns would subject the issuing entity to a number of penalties.  The penalties discussed are:

• Failure to File or Show Information on Partnership Return (IRC §6698);

• Failure to File or Show Information on an S Corporation Return (IRC §6699);

• Failure to File Correct Information Returns (IRC §6721);

• Failure to Furnish Correct Payee Statements (IRC §6722); and

• Failure to furnish information required by IRC §6038 related to Form 8865 (IRC §§6038(b) and (c))[3]

In most cases a failure would trigger more than one of these penalties absent a showing of reasonable cause for the failures.  The Notice provides transition penalty relief to entities that will have to file the Schedules K-2 and K-3 on 2021 returns.

Relief and Conditions to Obtain Relief

The Notice describes the relief broadly as follows:

This section provides transition relief for taxable years that begin in 2021 (processing year 2022) with respect to Schedules K-2 and K-3 to Forms 1065, 1120-S, and 8865. During this transition period, a partnership required to file Form 1065, an S corporation required to file Form 1120-S, or a U.S. partner required to file Form 8865 (a “Schedule K-2/K-3 filer”) will not be subject to the relevant penalties described in section 2 for any incorrect or incomplete reporting on the Schedules K-2 and K-3 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. A Schedule K-2/K-3 filer that does not establish that it made a good faith effort to comply with the new requirements will not be eligible for penalty relief under this notice.[4]

The Notice outlines criteria the IRS will consider in determining if the filer made a good faith effort to comply for purposes of this relief:

For purposes of determining whether a Schedule K-2/K-3 filer makes a good faith effort to complete Schedules K-2 and K-3, the IRS will take into account the extent to which a Schedule K-2/K-3 filer has made changes to its systems, processes, and procedures for collecting and processing information relevant to filing the Schedules K-2 and K-3 and the extent to which a Schedule K-2/K-3 filer has obtained information from partners, shareholders, or the CFP, or applied reasonable assumptions when information is not obtained. The IRS will also take into account the steps taken by the Schedule K-2/K-3 filer to modify the partnership or S corporation agreement or governing instrument to facilitate the sharing of information with partners and shareholders that is relevant to determining whether and how to file Schedules K-2 and K-3.[5]

The Notice explains that the IRS is aware that some of the items requested on these forms will require obtaining information about the interest holder:

In several instances, certain information about partners, shareholders, or the CFP is relevant for determining the applicability of a part of Schedules K-2 and K-3. For example, if a partnership has a direct or indirect partner that is a nonresident alien individual or a foreign corporation, the partnership must complete Form 1065, Part X of Schedules K-2 and K-3. Information about the partners, shareholders, or the CFP is also relevant for determining how to report some amounts. For example, for taxable years beginning in 2021, the instructions for Form 1065, Part IX of Schedule K-2 and K-3 state that a partnership is expected to collaborate with its partners to identify the foreign related parties of each partner.

The Treasury Department and the IRS are aware that a Schedule K-2/K-3 filer may not currently have systems or procedures in place to obtain information about its partners, shareholders, or the CFP to determine whether it must file a part of Schedules K-2 and K-3 or how to complete a part that must be filed.[6]

The Notice goes on to explain what the filer must do to qualify for relief for issues arising related to these items:

In general, in the taxable year 2021 instructions, unless the Schedule K-2/K-3 filer has knowledge to the contrary, it must file or complete certain parts assuming that the information would be relevant to the partner or shareholder. Under this notice, during the transition period, a Schedule K-2/K-3 filer will not be subject to the relevant penalties described in section 2 for any incorrect or incomplete reporting on Schedules K-2 or K-3 if it establishes to the satisfaction of the Commissioner that it made a good faith effort to determine whether it must file a part and how to complete a part that it files.

With respect to information about partners, shareholders, or the CFP that is relevant to determine whether to file and how to complete a part, the IRS will assess the effort the Schedule K-2/K-3 filer made to obtain this information and the reasonableness of any assumptions, taking into account the relationship between the Schedule K-2/K-3 filer and its partners, shareholders or the CFP. For example, the appropriate level of diligence and/or the reasonableness of an assumption may differ with respect to a partner that manages or controls the partnership, or a partnership with a partner with a significant interest in the partnership, such as a partner with a 10-percent interest, as compared to partners holding small interests for which there may not be the same ease of access to information. Nevertheless, a Schedule K-2/K-3 filer may have made a good faith effort despite being unsuccessful in obtaining information from its partners, shareholders, or the CFP.[7]

The important thing to note about this relief is that it is very much conditional relief—if the filer makes no effort to compile and obtain relevant information, the filer would not meet the conditions to obtain this relief.  For this reason, filers should begin studying the draft instructions and the forms, determining how the filer would be able to compile or obtain the necessary information, and begin documenting the steps being taken as well as the problems that arise in attempting to fully comply with the requirements.

Comments Being Requested

The Notice ends by requesting comments on the draft instructions to the various Schedules that were released at the same time as the Notice.  The nature of the comments requested is described as follows:

The IRS solicits comments on the draft instructions to Schedules K-2 and K-3 for taxable years beginning in 2021 being released the same date as this Notice, particularly any instances where the instructions do not provide sufficient guidance on how to complete the returns or where additional clarity is needed. The IRS is specifically interested in suggestions for addressing structures and situations that make it difficult to determine certain information (for example, tiered partnership structures or publicly-traded partnerships).

As discussed in section 3, in general, the instructions for taxable years beginning in 2021 for certain parts of the Schedules K-2 and K-3 require the partnership and the S corporation to report information unless the partnership and S corporation know that the information is not relevant to partners, shareholders, or indirect partners. The IRS solicits comments concerning reasonable assumptions Schedule K-2/K-3 filers could make in determining whether and how to complete Schedules K-2 and K-3 for years after the transition period and whether these assumptions may differ between various parts of the Schedules K-2 and K-3.[8]

The Notice describes the method for submitting comments as follows:

Comments should be submitted in writing and should include a reference to Notice 2021-39. Comments may be submitted in one of two ways:

(1) Electronically via the Federal eRulemaking Portal at www.regulations.gov (type IRS-2021-0006 in the search field on the regulations.gov homepage to find this notice and submit comments).

(2) Alternatively, by mail to: Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2021-39), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.

All commenters are strongly encouraged to submit public comments electronically. The IRS expects to have limited personnel available to process public comments that are submitted on paper through the mail and these comments, submitted through the mail, may not be processed with enough time before revisions to the instructions need to be prepared. Until further notice, any comments submitted on paper will be considered to the extent practicable. The Treasury Department and the IRS will publish for public availability any comment submitted electronically, and to the extent practicable on paper, to its public docket.[9]

[1] Notice 2021-39, June 30, 2021, https://www.irs.gov/pub/irs-drop/n-21-39.pdf (retrieved July 1, 2021)

[2] Notice 2021-39, Section 2.02

[3] Notice 2021-39, Section 2.03

[4] Notice 2021-39, Section 3

[5] Notice 2021-39, Section 3

[6] Notice 2021-39, Section 3

[7] Notice 2021-39, Section 3

[8] Notice 2021-39, Section 4

[9] Notice 2021-39, Section 4