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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 in 2022. The IRS has made it clear that there will be scenarios where 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 difficulty is a new filing requirement that was implemented this tax year – Schedules K-2 and K-3, used to report international tax activity for passthrough entities.

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 will be required for most partnerships going forward. Due to the breadth of scenarios that can trigger a requirement to file K2s and K3s, 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. They affect 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 have the same filing deadlines of March 15 without an extension or September 15, if extended. The purpose of these forms is to provide partners clarity on how to compute their US tax liability regarding international tax items.

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.

The IRS provided an exception for 2021 that 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.

Historical Context of Schedules K-2 and K-3 Releases

• May 2020: the IRS released initial drafts of Schedules K-2 and K-3.
• September 2021: the final versions were released after various updates.
• Dec. 2021 / Jan. & Feb. 2022: additional updates were released in response to commentary by tax professionals.

The IRS clarified that situations could arise where a partnership has no foreign activity and no foreign partners and is still required to file K2s and K3s, such as when partners intend to claim a foreign tax credit on their personal tax returns.

The future of the Tax Season for Fund managers

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. Going forward, unless the IRS releases further updates, the safest approach for most partnerships may be to assume that K2s/K3s are required.