A typical affordable housing partnership with 100% domestic operations may have items of international tax relevance notwithstanding that it has no foreign activity or partners. The domestic operations of the typical affordable housing partnership will be relevant to any direct or indirect partner who is impacted by international tax provisions of the Internal Revenue Code and who need specific domestic income and asset basis information in order to apply the international tax provisions on their tax returns. The new Schedules K–2 and K-3 report this necessary domestic operating information to the impacted partners.
This DOZ Insight will focus on the requirements of these Schedules as they relate to Form 1065. Generally, the Form 1120-S Schedules K–2 and K-3 contain similar, but less, Parts compared to their Form 1065 counterparts.
Planning for 2021 Tax Year-End
It is imperative that entities to whom these Schedules apply determine if and which of the 13 Parts of these new Schedules are applicable to their direct and indirect partners.
Because domestic housing partnerships do not likely have any international activity, several of the 13 Parts of the new Schedules K–2 and K-3 will not be applicable and will not need to be completed on the 2021 property level federal income tax return. However, because some of the partners in the typical domestic housing partnership may have international activity at the upper tier partner level, certain Parts of the new Schedules K–2 and K-3 may be required to be completed on the 2021 federal income tax return at the lower tier housing partnership level.
General and/or managing partners should have discussions with limited partners in order to identify which Parts of the Schedules K–2 and K-3 the limited partners need to complete their upper tier 2021 tax returns, so that general partners can instruct the property level accountants regarding which Parts of the Schedules K–2 and K-3 need to be completed on the property level tax returns.
These Schedules apply to entities that file either:
- Form 1065 (US Return of Partnership Income),
- Form 1120-S (US Income Tax Return for an S Corporation), or
- Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)
Reason for the Schedules K–2 and K-3
Historically, items of international tax relevance were reported in K-1 footnotes, whitepaper disclosures and pro-forma forms, all which varied from tax preparer to tax preparer.
The Schedules K–2 and K-3 are an attempt by the IRS to:
- Standardize information of international tax relevance,
- Ensure taxpayers have better clarity on how to calculate their US income tax liability when considering potential international-related items, and
- Make it easier for the IRS to verify taxpayer compliance on international tax matters.
The instructions to the Schedules K–2 and K-3 state that “The partnership need not complete this schedule if the partnership does not have items of international tax relevance (typically, international activities or foreign partners). Any partnership required to file Form 1065 and that has items relevant to the determination of the U.S. tax or certain withholding tax or reporting obligations of its partners under the international provisions of the Internal Revenue Code must complete the relevant parts of Schedules K–2 and K-3.”
While a domestic passthrough entity might not have international activities or foreign partners, information from its domestic activities can be needed by certain direct or indirect partners in their calculations of US international tax items. Therefore, domestic activities can have international tax relevance, necessitating a Schedules K–2 and K-3 filing requirement.
Parts of Schedules K–2 and K-3
The Form 1065 Schedule K–2 has 12 Parts, while the Schedule K-3 has a 13th Part, as noted below. A partnership is only required to complete the relevant portions of Schedules K–2 and K-3, as applicable. The following are brief descriptions of each Part:
Part I – Partnership’s Other Current Year International Information
Used to report international tax items not reported elsewhere on Schedule K–2 or K-3. The partnership will check the applicable box to indicate whether any of the specified international tax items listed in boxes 1-12 are applicable in the tax year. If applicable, the partnership may need to attach additional statements.
Part II – Foreign Tax Credit Limitation, and
Part III – Other Information for Preparation of Form 1116 or 1118
Certain partners will use the information in Parts II and III to claim and figure a foreign tax credit on Form 1116 or 1118. Schedules K–2 and K-3, Parts II and III, must be completed unless the partnership does not have a direct or indirect partner that is eligible to claim a foreign tax credit, and such partner would have to file a Form 1116 or Form 1118 to claim a credit. This requirement applies regardless of whether the partnership pays or accrues foreign taxes because other information, such as the source of the partnership’s income and the value of its assets, are relevant in determining the partner’s foreign tax credit.
Part IV – Information on Partners’ Section 250 Deduction with Respect to Foreign-Derived Intangible Income (FDII)
Certain partners will use the information in Part IV to claim and figure a section 250 deduction with respect to FDII on Form 8993. This part is used by the partnership to report information to a direct domestic corporate partner (other than real estate investment trusts, regulated investment companies, and S corporations), or to a partner which is a partnership that has a direct or indirect domestic corporate partner (other than real estate investment trusts, regulated investment companies, and S corporations) needed to determine the domestic corporate partner’s FDII. Any partnership with direct or indirect domestic corporate partners must complete this part, though the partnership does not have foreign-derived gross receipts. Even if a partnership has no foreign activities, and therefore has no foreign-derived deduction eligible income as reported in Section 2 of this part, the partnership must still report the information required by Sections 1 and 3 of this part so that any domestic corporate partner can correctly determine its section 250 deduction.
Part V – Distributions From Foreign Corporations to Partnership,
Part VI – Information on Partners’ Section 951(a)(1) and Section 951A Inclusions,
Part VII – Information To Complete Form 8621, and
Part VIII – Partnership’s Interest in Foreign Corporation Income (Section 960)
If the partnership does not own (within the meaning of section 958) stock of a foreign corporation other than solely by reason of applying section 318(a)(3) (providing for downward attribution) as provided in section 958(b), it is not required to complete Schedules K–2 and K-3, Parts V, VI, VII, and VIII.
Part IX – Partners’ Information for Base Erosion and Anti-Abuse Tax (Section 59A)
Certain partners will use the information in Part IX to complete Form 8991. Part IX of Schedules K–2 and K-3 must be completed by a partnership to assist its corporate partners in determining if they are subject to the Base Erosion and Anti-Abuse Tax (BEAT), and to figure their Base Erosion and anti-abuse tax, if any.
Part X – Foreign Partners’ Character and Source of Income and Deductions
Certain partners will use the information in Part X to figure and report their U.S. tax liability on Forms 1040-NR and 1120-F, or other applicable forms. In general, the Schedules K–2 and K-3, Part X, must be filed by every partnership that has a foreign partner, or if a foreign person has a U.S. income tax reporting obligation with respect to any item of partnership income, deduction, gain, or loss.
Part XI – Section 871(m) Covered Partnerships
Certain partners that enter into section 871(m) transactions referencing units in the partnership will use the information in this part to determine their U.S. withholding tax and reporting obligations with respect to those transactions under section 871(m) and related rules. Schedules K–2 and K-3, Part XI, must be completed if you are a publicly traded partnership as defined in section 7704(b) (a “PTP”) that is a covered partnership as defined in Regulations section 1.871-15(m)(1) (a “covered partnership”) or directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership, regardless of whether the partners are domestic or foreign.
Part XII – Reserved
(N/A for 2021)
Part XIII – Foreign Partners’ Distributive Share of Deemed Sale Items on Transfer of Partnership Interest
Certain partners will use the information in Part XIII to complete Form 4797, Sales of Business Property, and Form 8949, Sales and Other Dispositions of Capital Assets. Note: There is not a corresponding part on Schedule K–2 with respect to Schedule K-3, Part XIII. This part provides the information for a foreign partner to use to determine the gain or loss it reports on its return from the transfer of an interest in the partnership. This part generally applies to a partnership that is directly or indirectly engaged in the conduct of a trade or business in the United States (U.S. trade or business) and had a foreign partner if either: 1) The foreign partner transferred an interest in the partnership (including a distribution that results in the recognition of gain or loss to a partner (see Regulations section 1.731-1(a)), or 2) The partnership directly or indirectly transferred an interest in a partnership that engaged in a U.S. trade or business.
Please contact your DOZ professional if you have any questions.