When it comes time to sign your company’s 2021 tax returns this year, you may notice something: It’s a little bit heftier. For that, you can thank Congress. As part of the 2017 tax overhaul, new filing rules impact just every small and mid-sized “pass-through” business in the country.
According to the nonprofit Tax Foundation, more than 90% of U.S. companies are pass-through businesses, which means their earnings “pass-through” to their shareholders’ individual tax returns. Usually, a pass-through entity files a partnership or an “S-Corporation” return. To report those earnings, the shareholders or partners in that firm have traditionally received a Schedule K-1, which allocates to them the share of income they must include on their individual tax returns.
But apparently, the company’s earnings are enough anymore. The IRS is now asking for more information to be reported to both shareholders … and the government.
For 2021 tax returns, there are now two additional forms that will need to be filed. A K-2 and K-3. The K-2 form must now report partners’ “total international distributive share items,” and the Schedule K-3 has to show a partner’s “share of international income, deductions, credits, etc.”
What does this mean? According to the most recent update from the IRS, even if the entity has no foreign income, no foreign taxes paid or accrued, no foreign assets and no other foreign activities, they may still need to file Schedules K-2 and K-3 if the owners of the entity are eligible to claim a foreign tax credit. How do you know that a partner is eligible to do this? I guess you can ask. But if you’re still not sure, you better file the additional schedules anyway.
If your company is one of the tens of millions that file a pass-through income tax return and you have just one partner who may — may — have other “interests” overseas, be it investments, family income or other business activities, then you’re likely going to have to also file the K-2 and K-3 schedules. And although not all information will need to be completed, the additional schedules will add 39 additional pages to a typical business tax return this year.
“Since not all entities have complete transparency into their indirect owners, the assumption is that virtually every partnership and every S Corporation will have to include these forms with their returns and the K-1s they provide to their owners,” writes Michael J. Greenwald of accounting firm Friedman LLP. “Even in a tax software environment, much of the information must be input manually. Add to that the fact that the IRS isn’t yet prepared to receive the information electronically and won’t be until sometime this summer, so the forms will actually have to be attached to e-filed returns as PDFs.”
Translation: more work, more fees, more headaches.
The good news here is that the IRS will be allowing some taxpayers to avoid penalties this year if they can show a “good faith effort” was made to comply with the requirements. But that’s only for this year.
The new rules are intended to provide partners with international activities with more financial information about their firms to help them comply with their own international tax requirements. But — no big surprise here — it’s also providing the IRS with even more data about these small businesses and the partners who invest in them so that the agency can match income and ownership data with other sources. And ask questions, of course.
The reporting change couldn’t have come at a worse time for countless small and mid-sized businesses struggling to emerge from the pandemic and get their feet on solid ground. It adds costs and paperwork and fees … and potential penalties if ignored. But it’s not just the taxpayers who have to deal with this new rule. It’s also the IRS.
The agency has already warned the public that refunds may be significantly delayed due to backlogs and pandemic and budget-related resource issues. Adding on this additional burden will only cause more stress on the agency and could further delay taxpayers’ refunds.
“(Although) many tax professionals on social media have noted that, while they understand that the new requirements are an important part of closing the part of the tax gap related to foreign tax reporting,” writes Amber Gray-Fenner in Forbes. “Perhaps the IRS should be focused on clearing the existing backlog of unprocessed returns, amended returns, and notice responses before implementing a new requirement that could possibly generate an avalanche of new notices (and unprocessed responses).”
A great suggestion but unfortunately not one that will be acted on. My advice to small business owners is to allow even more time for their returns to get completed by their accountants and to be prepared to provide even more information to them — and the government — about your business going forward.
• Gene Marks is a CPA and owner of The Marks Group, a technology and financial management consulting firm specializing in small- and medium-sized companies.