Blog
Top K-1 Myths: Myth 2
BY Scott Turner
August 27
“We need to wait until the IRS does something about it”
I think this statement might fall into the category of: “be careful what you wish for.”
Introduced beginning with the 2021 tax year, Schedules K-2 and K-3 essentially took line 16 on the Schedule K-1 and expanded it into a 20-page document. The intent was to provide more structured data and transparency than previously provided through white paper statements. But the jury’s out as to whether this transparency and clarity actually transpired. First glances at these documents would indicate that the structured forms largely have not have alleviated the free-form white paper many previously hoped.
Despite the introduction of the K-3, the IRS still has not planned for an overhaul of the Schedule K-1. While we can’t say we know for sure why the IRS hasn’t fixed this, my theory is that they already get their data in a digital format that is standardized.
(I’ll let that one sit for a minute.)
When tax returns are prepared, they are submitted to the IRS in a standard XML format. That’s the actual IRS form plus the overflow white paper statements of all the details of the IRS form — approximately 220 fields of data. That is enough information for the IRS to do their matching of the partnership and partners, and then determine if there’s tax left unpaid. The IRS wanted to dig deeper into foreign activities, thus the introduction of the K-2 and K-3, which are also standardized.
Since the IRS receives what they’re looking for in a format they need, there is no urgency for them to fix a problem that technically doesn’t exist…for them.
Since the IRS receives what they’re looking for in a format they need, there is no urgency for them to fix a problem that technically doesn’t exist…for them.
Another important item disclosed in the K-1 packet is state information.
Even if the IRS wanted to take a bigger role in digitizing the industry, it would also have to coordinate with the states. Of all 50 states, 42 have an active role in the partnership arena. Most of these states require an electronic filing, which provides them with the particular data that each state requires. Many states also have required withholding or allow the partnership to pay a composite tax on behalf of its partners. So technically, the states have already received their money — and usually at a higher rate — than what the partners would have paid on their own.
State data provided in the K-1 also means something different to partners depending on their legal entity type: individual, corporate, or exempt. Generally, individuals would file in their resident state and may use the state payments as a credit in their home state. Corporations would be interested in the apportionment factors (this is that big schedule that has all 50 states on the left-hand side and the property, payroll, and sales items listed out) so they can combine them with their other activities to determine their state tax filing responsibilities and calculate the total tax due. Tax exempts almost never get what they’re looking for — that’s unrelated business income broken down by state.
State data provided in the K-1 also means something different to partners depending on their legal entity type: individual, corporate, or exempt.
And then there are international entities. Besides what is now being collected on the schedule K-2 and K-3 there’s a lot more to consider. The K-2 and K-3 forms are focused on the foreign tax credit and the alphabet soup of FDII, GILTI, PFIC, QEF, and others, but there are still a lot of white paper footnotes providing details on the transfers of cash or goods outside of the U.S. Many institutional investors will complete hundreds of Forms 926, 8865, etc., reporting their cash transfers of more than $100K or any amount of non-cash. Tracking this information is brutal since you must track transfers collectively (amongst the entire portfolio) and go back within a 12-month period. There is no standardization of how to report this information and it’s probably one of the highest risk areas within a K-1 project. Besides the tedium of tracking and completing all the forms, the biggest risk comes when forms are not filed at all. In fact, companies could face a $10K penalty per form missed.
Companies face
$10K
penalty per form missed
In sum, the IRS, for the most part, gets what they need between the K-1, K-2 and K-3. The states, for the most part, get what they need, which is payment of tax through withholding or composites. So what else is there in the K-1 packet?
Everything else a partner receives in a K-1 packet is information that the partner needs to complete its own tax filings. Examples of this for an individual would be how much of the taxable income distribution is passive or active. Meanwhile, exempt entities would be looking for how much of the taxable income is unrelated business income for which the exempt needs to calculate and pay a tax. And finally, corporate entities may be most interested in additional deductions.
The preparers are challenged by providing relevant data to 15 different legal entity types that would assist them in filing their own federal and state returns. Most handle this process by overloading K-1s with every possible bit of information and then state “consult your tax advisor.”
But there is a better way to handle this process.