Updated instructions for the painful K2/K3s

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Does anyone remember the horrendous start to the 2022 tax season or have we all blacked that out at this point? CPAs across the country filed an unprecedented number of extensions, especially for passthrough entities, when the IRS, at the last minute, dropped the K2/K3 bomb.

Schedule K2 and K3 were meant to enhance the foreign reporting requirements of passthrough businesses to be more in line with the foreign reporting requirements currently required by C Corporations. Things got out of hand quickly when it started to become clear that the massive schedules were required if a shareholder even so much as received a personal 1099 with foreign dividends on it. YIKES.

Most of us were not prepared going into tax season this year as the schedules themselves were barely released prior to returns being due, let alone any version of well understood instructions. The delays  compressed the time to file as individual partners and shareholders waiting for clarity that came way too late in the game.

The IRS was accepting comments on the updated draft instructions through Nov. 8, but in the recently released draft we already not new filing exceptions. Unfortunately, as of now, the current draft still retains confusion around foreign reporting requirements when it comes to partners and shareholders who file Form 1116 for reporting foreign credits.

The instructions still seem to imply that a passthrough business with no foreign activities, and no foreign shareholders or members, may still be required to fill out the lengthy forms if any of its shareholders or members claims a credit on Form 1116.

The biggest challenge for CPAs is then taking into consideration how they determine the requirement for reporting, especially in circumstances where your firm may not prepare the individual returns of every shareholder/member of the passthrough.

To get ahead of the curb this year, since so far the instructions seem to imply we’ll be facing the same reporting burden as last year, send out organizers and checklists to passthrough business clients early. Make sure to include questions about this information and specifically ask them to attest as to whether or not any individual shareholders or members have filed Form 1116 in the past.

At the very least this helps to start identifying which clients may potentially be required to file these forms.

Given the lengthy and complexity of the reporting, it also is important to have a discussion with clients now about their preparation fees when you know that these schedules may be required. 

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