New K-2 and K-3 Forms: Crisis or Headache?

The IRS is still catching up with returns filed as far back as last April. Millions of pieces of correspondence sit unread in mail bins at IRS service centers. The IRS is desperate to hire more help, but has only been able to fill less than 10% of 5,000 open positions. 

So it's time for the IRS to introduce a complicated new tax form. Partnerships and S corporations are required this year to generate new Schedules K-2 and K-3, in addition to the K-1s they have always produced. These forms gather information on international tax items and report them to partners and shareholders.

If you have read this far and have relaxed because your business is purely domestic... keep reading.

While a partnership and S corporation may operate entirely within the U.S., its owners may need information on the K-2/K-3 filings to determine foreign-related items, including the foreign tax credit. The IRS wants them to provide that info on the new forms. 

The forms are intimidating. Schedule K-2, which gathers the information on the business tax form, is 19 pages, not counting instructions. Schedule K-3, which reports this information to partners and S corporation shareholders, is 20 pages.

Fortunately, most taxpayers will only need to deal with a small portion of these forms. The key new items that haven't been historically provided for most shareholders include:

- Sales and cost of goods sold

- Gross service income

- Gross real estate rental income

- Other gross rental income

- Business interest expense

- Average tax basis of business and investment assets

Taxpayers with research expenses will also have to break that out for owners by SIC codes, which is a new thing.

Most domestic businesses have not been required to report this information before. Fortunately, it is probably available to most filers. Unfortunately, it will take taxpayers time to sort it out. Tax preparation software is not yet equipped to handle the new forms efficiently, so they require time-consuming manual input for preparers. 

Does everyone have to file this? The IRS partnership instructions say businesses can skip the K-2 / K-3 filing only if they "have or receive sufficient information or notice" that no owners need it for an international tax computation (most commonly to claim a foreign tax credit). Not many businesses have this sort of information for all of their owners.

Can we just ignore it? Bad idea. There is a non-zero chance the IRS will just let this slide, but that's a dangerous bet. Failure to file the forms could trigger penalties including the $210 per month, per K-1, penalty for late filing.

Bottom line: The new form requirements are annoying, costly, and probably unwise under the circumstances. Still, panic is unwarranted. Most taxpayers should be able to dig up the information they need for filing.