Schedules K-2 and K-3: What does this mean for Fund managers?

Key Takeaways: 

If you only have a couple of minutes to spare, here is what Fund managers should know about K-2s and K-3s:

• New schedules are related to items of international tax relevance: the new schedules apply to passthrough entities, including LLCs and Limited Partnerships, the two most commonly used entities for Funds. Their purpose is to provide partners clarity on how to compute their US tax liability with regards to international tax items. 

• Application will be broad: the schedules applied to a narrow range of criteria in 2021, focused on foreign assets or partners, but this is expected to change 2022. The IRS has made it clear that there will be a range of scenarios a partnership has no foreign activity and no foreign partners and is still required to file K2s and K3s. 

• The Schedules require a lot of work: the new forms, at 19 pages for Schedule K-2 and 20 pages for Schedule K-3, replace what were previously single line items in the partnership tax return and K-1. This means that many filers now need to report information that they did not previously know was required or in much greater detail.

• Safest bet for Fund managers may be to file K-2s and K-3s for all Funds in 2022: due to the broad filing requirements, Schedules K-2 and K-3 will become common parlance in future tax years and will need to become part of Fund managers’ vernacular.

As the tax season is drawing to a close, many tax professionals are looking forward to putting a particularly trying tax season behind them. The source of much of the difficulty is a new filing requirement that was implemented this tax year – Schedules K-2 and K-3, which are used to report international tax activity for passthrough entities.

The new Schedules K-2 and K-3 have been the subject of a lot of discussion within the tax community during 2021, but many Fund managers have limited understanding of what these new forms are and when they are required.

This article provides an overview of Schedules K-2 and K-3 for Fund managers and addresses common questions related to the new filing requirements. 

Why Do I Need to Know This? 

The new Schedules K-2 and K-3 are going to be required for most partnerships going forward. Due to the breadth of scenarios that can trigger a requirement to file K2s and K3s (more on this below), in future tax seasons, the question “are you issuing K-3s this year?” may become almost as common as the question “where are my K-1s?” 

Fund managers can be better equipped to respond to this and related questions with a general understanding of what K-2s and K-3s are and when they need to be issued to investors.

What are Schedules K-2 and K-3?

Schedules K-2 and K-3 are a new requirement for passthrough entities for the 2021 tax season. The requirement effects LLCs and Limited Partnerships, passthrough entities that are considered “partnerships” for tax filing purposes and are the most common entity types used for funds. 

Schedule K-2 reports international tax items at the partnership level and Schedule K-3 reports each partner’s share of international tax items. Like K-1s, K-3s are distributed to each partner for use in filing their personal tax returns.

Schedules K-2 and K-3 are due with the partnership’s tax return and, thus, have the same filing deadlines of March 15 without an extension or September 15, if extended.

Schedules K-2 and K-3 are used to report “items of international tax relevance” and are an extension of the existing partnership tax return, Form 1065. While some Fund managers may not be familiar with the term “Form 1065”, almost all Fund managers will be familiar with Schedule K-1, the section of the tax return that is distributed to LPs each year so that they can complete their personal tax returns. For most Fund managers, the first quarter of each year is usually punctuated by emails from LPs asking when they can expect their K-1s, and, as mentioned above, this may extend to K-3s in future tax years.

The purpose of the new Schedules K-2 and K-3 is to provide partners greater clarity on how to compute their US tax liability with regards to international tax items. 

When the IRS released the new schedules, it stated that they are meant to better define the existing reporting requirements and would not add any new reporting requirements. However, the new forms, at 19 pages for Schedule K-2 and 20 pages for Schedule K-3, replace what were previously single line items in the former version of the partnership tax return and K-1. This means that, in practice, many filers now need to report information that they did not previously know was required or in much greater detail.

When do you need to file Schedules K-2 and K-3?

The short answer is that Schedules K-2 and K-3 are required when there are “items of international tax relevance” in connection with the partnership.  

The definition of “items of international tax relevance” is fairly broad and was the source of some confusion during the 2021 tax season. As a result, the IRS provided an exception for 2021 that only required partnerships to file Schedules K-2 and K-3 if they met any of the following criteria:

• The partnership had foreign assets or income in 2021.

• The partnership had foreign partners in 2021.

•  The partnership had knowledge that any of its partners was requesting the type of information that would be reported on Schedules K-3.

As mentioned, these three filing triggers are narrowed in scope from the full list of situations when a filing might be required in future tax years.  

To understand what the filing triggers would otherwise be (and what they will likely be in the future), as well as the reason for the narrowed scope for this year, it’s useful to have a brief history of the IRS’s release of and subsequent updates to the new schedules.

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• May 2020: the IRS released initial drafts of Schedules K-2 and K-3.

• September 2021: after various updates, the final versions were released.

• Dec. 2021 / Jan. & Feb. 2022: in response to widespread commentary by tax professionals on these final versions, additional updates to the final versions were released in December 2021, January and February of 2022.

The IRS released initial drafts of Schedules K-2 and K-3 in May 2020. After various updates, the final versions were released in September 2021. In response to widespread commentary by tax professionals on these final versions, additional updates to the final versions were released in December, January, and February of 2022.

It was in the January 2022 release, an update to the K2/K3 instructions, that the IRS specified the full extent of when partnerships (and all passthrough entities) are required to file Schedules K-2 and K-3. 

Prior to this release, most filers assumed that the “items of international tax relevance” that would trigger a filing were foreign assets or income or foreign partners. However, the IRS clarified that there may be situations where a partnership has no foreign activity and no foreign partners and is still required to file K2s and K3s, for example, when any of the partners intends to claim a foreign tax credit on their personal tax return. 

A foreign tax credit is a credit that a taxpayer can claim on their tax return if they paid or accrued foreign tax liability and are subject to U.S. tax on the same income.

For the K2/K3 tax filing requirement, unless the partnership knows that none of the partners will be claiming a foreign tax credit, then the partnership is required to file.

This means that in order for a partnership to determine its filing requirement, it must poll its partners to see whether any of them will be claiming a foreign tax credit. This can create a significant administrative burden for partnerships with a large number of partners, or, in the case of Fund managers, managers with a large investor base.

Due to concerns over the additional burdens caused by the breadth of the filing requirement, and the fact that the clarification around the filing trigger came in the midst of tax season, on February 16, 2022, the IRS released a filing exception for the 2021 tax year, narrowing the scope of when a filing is required to the three scenarios listed previously.

Going forward, unless the IRS releases any further updates to the K2/K3 filing requirements, the safest approach for most partnerships may be to assume that K2s/K3s are required, which means that these forms will become a routine part of the tax filing process in the upcoming tax season and beyond.  

The future of the Tax Season for Fund managers

Due to the broad filing requirements, Schedules K-2 and K-3 will become common parlance in future tax years and will need to become part of Fund managers’ vernacular. Fund managers should be prepared to answer questions from their investors about these new schedules and should talk to their Fund administrators or tax preparers if they have questions.

For Fund managers who have taken the do-it-yourself route to tax preparation for their funds, they may need to engage a fund administrator or tax professional going forward due to the complexity of the new schedules.

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The information contained in this article is not tax advice and readers should not act on any information presented in this article without consulting a tax consultant.

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