Schedule K-3 questions and answers to recently released instructions

A: The IRS introduced the Schedule K-3 to help partners and shareholders by clarifying calculations of U.S. income tax liability, as well as income and deductions related to international activity.

Before tax year 2021, foreign informational disclosures were reported to the investors on their Schedule K-1 Line 16 and footnote sections. In tax year 2021, all that information needed to be reported on the new Schedule K-3. In fact, all pass-through entities with items of international tax relevance were required to file a Schedule K-3.

In the IRS’ answers to frequently asked questions, it acknowledged that partnerships and S corporations would initially have transition costs, but the agency asserted those entities would benefit from increased transparency of information and reduced uncertainty about what to report and how to report it.

A: The new schedules required more detailed and more complete reporting than many partnerships and S corporations provided previously to partners and shareholders. This created a major compliance hurdle for various entities, including private equity and real estate funds.

Schedule K-2 and K-3 require a significant amount of information to be reported. The Schedule K-3 is about 20 pages long and does not take into consideration any overflow statements or supplemental disclosures. Schedule K-3 requires country-by-country reporting, which, as you can imagine, could be voluminous.

A: It was a challenge, to say the least. The IRS released the Schedule K-3 instructions and the Schedule K-2 and K-3 FAQs in February 2022 but continued to update them through September, which left tax advisors with only a brief period to understand the reporting requirements across their various clients. We worked closely with our international tax team to understand the requirements. This helped us scope the requirements from clients to ensure we received the information that needed to be reported on the forms, such as the country of incorporation.

A: We knew it would be a challenge, especially in the fund-of-funds space, where you may receive underlying Schedule K-3s from various tax preparers. We had to aggregate all the Schedule K-3 data in a concise manner in order to enable clients to report to their investors. This meant reconciling items between the various sections of the form and Schedule K-1 and Schedule K-3. There were occasions where we had to go back to clients to ask them questions with regards to the Schedule K-3 and in some cases request the Schedule K-3 because it was not provided.

A: Like most tax compliance processes, we look for ways to improve each year. On the client side, the data-gathering process has been vetted, which will allow the team to provide more value-added services. On the advisory side, we will look for ways to streamline the data with tax applications like PartnerSight^®.

A: The Schedule K-3 contains over 700 data points. An application like PartnerSight can aggregate and tier the Schedule K-3 data in a structured format and generate the forms. This is a game changer because it is more efficient and minimizes the risk of human error.

A: As the tax regulatory footprint continues to evolve, our clients should be aware of these changes so that we can work closely with the administrators to ensure we have the data points we need.

Clients are being more proactive in reaching out to us to understand their requirements if they make a new investment in a foreign jurisdiction and are initiating information requests from underlying portfolio companies much earlier than usual. We saw delays in receiving underlying K-1s, ranging from two to four weeks in comparison to the prior year. It also facilitates collaboration with our international tax specialists, which deepens the insights for the investment funds we serve.