What Investment Clubs Need to Know about IRS Schedules K-2 and K-3
New IRS requirements for investing partnerships take effect for the 2021 tax year.
It’s hard to summarize the situation regarding the new IRS Schedules K-2 and K-3 in a few words, expecially since the IRS has not done a good job explaining it themselves and has flip-flopped and backtracked on their guidance.
But here is what ICLUBcentral knows as of early March 2022:
The IRS introduced Schedules K-2 and K-3 that are effective for tax year 2021. These forms are used to report additional information on Schedule K-1 transactions, including foreign source income (such as, but not exclusively, dividend income from foreign companies). Schedule K-2 is filed with the Form 1065 return, while Schedule K-3 is given to partners and also filed with the return.
Key to the schedules is identification of the source of foreign income. A foreign company is defined by the IRS as any company that is not a US company. Our interpretation of their definition is that the key is where the company is incorporated. This is not where the company may primarily operate or where their headquarters are located. Many “Chinese” companies are not incorporated in China, for example.
Along with the amount received and the name of the security, the country of a foreign company must be reported on the new schedules. This is why all securities must now have their countries identified in myICLUB.com.
Hardly any parts of the new Schedules K-2 and K-3 apply to investing partnerships like typical BetterInvesting-style investment clubs. The IRS has made some clarification about the proper completion of the forms since they were released, but took some time for the industry to get to the point where there is some sort of consensus about which parts are relevant to investment clubs.
For most investment clubs, Parts II and III will be the only part of the schedules that have values. Parts I and Parts IV to XIII are not applicable to clubs and will have no values.
The myICLUB.com Club Tax Printer handles these forms for e-Filing as well as paper-generated forms. However, the full schedules are both around 20 pages in length, which makes for a very large Form 1065 submission when printed. A club of 12 members could see their IRS return total more than 400 pages!
Members now download their Schedule K-3 along with their K-1 from the myICLUB.com website. We suggest that treasurers NOT try to print them since the combined K-1, K-1 instruction sheet, and K-3 could be as much as 25 pages for each member.
Since the completed K-3s for each partner must be included with the Schedule K-2 and the full Form 1065 and all other related schedules, a completed club return could now total hundreds of pages, so e-Filing with myICLUB.com is definitely a better option. (On a technical note, the IRS is not including the new Schedules in its e-Filing schema until March 20; before then, PDFs of the schedules are to be attached to any e-Filed return, which is how the myICLUB.com Club Tax Printer is handling it. This is invisible to the end user, and our e-Filing programming handles it all.)
Schedule K-3 is required to be delivered to any partner who is claiming a foreign tax credit on their personal tax return using IRS Form 1116. This may be the case even if the partnership had distributed no foreign tax credits to partners -- the IRS still requires the partnership to report that no foreign source income was distributed to the partner.
There is a process for partnerships to opt out of completing K-2 and K-3, but this requires all partners to validate that they will not be claiming foreign tax credit using IRS Form 1116 on their personal returns. Since the individual filing deadline for the IRS is April 15, it may not be possible for individual partners to know whether or not they will be using Form 1116 by the partnership filing deadline of March 15. As a result, the myICLUB.com Club Tax Printer generates K-2 and K-3 for all clubs and all members. The IRS did create another loophole for clubs that have no foreign income to report, but this came late in the tax filing season for investing parnterships. This current situation does create an enormous paper trail, but in our view this is preferable to not generating or filing the forms when they might be required.
States that require copies of a partnership's Form 1065 and related schedules to be included with their state's returns have also largely not updated their instructions, so these states will be inundated with paperwork for the 2021 tax year.