The AICPA and the state societies of CPAs on February 24, 2022[1] sent a letter to Lisa Batchelder, Assistant Secretary (Tax Policy) Department of Treasury and IRS Commissioner Charles P. Rettig asking for a delay in the requirement for partnerships and S corporations to complete and file Schedules K-2 and K-3 reporting items relevant to international tax reporting.

The IRS began requiring completion of Schedule K-2 and Schedules K-3 if the partnership or S corporation had any items of international tax relevance for tax years beginning after December 31, 2020. However, the IRS announced in December they would not be able to accept such forms in the regular MeF/XML filing system until after the due dates for affected returns.[2]

As well, on January 18, 2022 the IRS issued an online update to the instructions that clarified that, despite the wording of the first sentence in the “Who Must File” section of the instructions released back in August of 2021, even partnerships and S corporations with no international transactions or foreign equity holders may have items of international tax relevance requiring the entities to complete the forms.[3] The key item driving such a requirement for those entities would be equity holders who needed information on even U.S. source gross income and assets located in the U.S. to complete Form 1116, Foreign Tax Credit.

The AICPA letter begins by recognizing the reasons why the IRS developed these forms:

A streamlined and expanded reporting tool of complex matters through fiscally transparent entities was undeniably necessary and we appreciate the importance of IRS’s foreign passthrough reporting requirements. We also acknowledge the substantial efforts of Treasury and the IRS in developing redesigned international tax reporting passthrough forms of Schedules K-2 and K-3 (the “Schedules”), releasing final instructions, and providing certain transition relief for 2021 tax years. Filing complete and accurate returns are essential elements to a well-functioning and voluntary tax system.[4]

But the letter goes on to note the impact of the implementation issues that have plagued the attempt to get these forms filed with 2021 returns:

However, recent revisions pertaining to the Schedules’ filing instructions raise additional questions, perpetuating futility in filing a complete and accurate return and the goal of standardized international reporting. Further modifying the applicable scope of the new Schedules amidst tax filing season leaves the tax system confused and in disarray. The AICPA previously recommended that due to implementation difficulties, such as software development and the Coronavirus pandemic impacting the entirety of the 2020 filing season, a delay until 2023 was necessary.

In footnotes to this section the AICPA refers to changes in the scope of filing issued on February 18, 2022 and inconsistencies the Institute notes in the FAQ issued that day regarding the scope of the relief:

For example, the “know or reason to know” standard regarding indirect partners included in FAQ 15 is inconsistent under current statutes and guidance (e.g., section 6031). Additionally, FAQ 15 lacks a bright-line standard by conflating direct and indirect partner reporting obligations.[5]

The AICPA formally recommended the following delays in the letter:

We continue to urge the IRS to delay implementation of the Schedules K-2 and K-3 to 2023 (the 2022 tax year filing season). If the IRS is not prepared to electronically accept the new Schedules in time for the initial filing dates of these forms, the filing requirement should apply for tax years beginning after the date the IRS and software providers are able to properly provide and process the new schedules in an electronic format. Further, we recommend no assessment of penalties against Partnerships or S Corporations for failing to file or failing to timely provide Schedules K-2 and K-3 for the 2021 tax year.[6]

Anticipating the IRS’s response of pointing to Notice 2021-39’s discussion of reasonable cause relief, a defense the IRS attempted to use previously in this controversy[7] before issuing the FAQ on February 18, 2022, the AICPA noted in a footnote to the above paragraph in the letter:

Notice 2021-39 provided penalty relief for good faith compliance efforts. However, this relief is insufficient given the 2022 updates to the final instructions.[8]

The AICPA letter states that “[d]elay is essential until e-filings can be accepted and uncertainty regarding taxpayer filing obligations is resolved” and specifically notes the issues caused by the IRS’s own inability to handle electronically filed versions of the form:

Currently, the IRS is unable to accept electronically filed returns containing the Schedules K-2 or K-3 via the Modernized e-File (MeF) system for partnership returns until March 20, 2022, and for S corporations returns until mid-June. The lack of a timely available MeF filing option for these forms in electronic format will cause unnecessary hardship to all affected parties.

These tentatively planned dates to accept e-filings are past the original due dates for all passthrough returns, which — given the continual changes regarding applicable filing obligations and MeF system unavailability — will presumptively necessitate filing extensions for significantly more partnership, S corporation, and owners’ individual income tax returns than in prior years. A major consequence of not having an MeF option is that the IRS will be tasked with processing unnecessary extensions in addition to the paper-filed returns for those entities who choose not to extend. Software providers also cannot offer sufficient solutions until the MeF system is complete.[9]

The letter concludes:

The 2022 filing season has commenced and the IRS as well as taxpayers are unclear as to who is required to file the Schedules (emphasis in the original document), nor can taxpayers properly file and the IRS process these Schedules. These threshold issues nearly preclude complete and accurate returns for the 2022 filing season on which our tax system relies and on which the Schedules are predicated in the goal to standardize international tax reporting.[10]

From a practical perspective any relief would need to come quickly to be at all relevant for partnerships and S corporations who plan to file their tax returns by the rapidly approaching unextended due date of March 15 for calendar year entities. As well, it’s likely entities that are planning to file on time have already expended significant time dealing with this issue, lost time that wouldn’t be remedied by the relief even if such relief had been granted on the day the letter was sent.

A better possibility for practical relief is that the letter may make it clear to the IRS the need to have broad based penalty relief on this issue for 2021 return filings, rather than the limited relief offered up by Notice 2021-39.

[1] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022, https://us.aicpa.org/content/dam/aicpa/advocacy/tax/downloadabledocuments/concerns-regarding-schedules-k-2-and-k-3-reporting.pdf (retrieved February 27, 2022)

[2] “Schedules K-2 and K-3: Interim Electronic Filing for Tax Year 2021,” IRS website, December 3, 2021, https://www.irs.gov/e-file-providers/schedules-k-2-and-k-3-interim-electronic-filing-for-tax-year-2021 (retrieved February 27, 2022)

[3] “Changes to the 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065),” IRS website, January 18, 2022, https://www.irs.gov/forms-pubs/changes-to-the-2021-partnership-instructions-for-schedules-k-2-and-k-3-form-1065 (retrieved February 27, 2022), “Changes to the 2021 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S),” IRS website, January 18, 2022, https://www.irs.gov/forms-pubs/changes-to-the-2021-s-corporation-instructions-for-schedules-k-2-and-k-3-form-1120-s (retrieved February 27, 2022)

[4] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022

[5] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022, Footnote 4

[6] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022

[7] See Kristen A. Parillo, “IRS Feels Your Pain on Schedules K-2 and K-3,” Tax Notes Today Federal, February 14, 2022, https://www.taxnotes.com/tax-notes-today-federal/information-reporting/irs-feels-your-pain-schedules-k-2-and-k-3/2022/02/14/7d60f (subscription required, retrieved February 27, 2022)

[8] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022, Footnote 6

[9] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022

[10] “Concerns Regarding Schedules K-2 and K-3 Reporting,” Letter from the AICPA and State CPA Societies, February 24, 2022