Many partnerships and S corporations may have noticed their 2021 income tax returns included considerably more pages than in prior years. This was in large part due to the new Schedule K-2 and Schedule K-3 filing requirements for pass-through entities that were effective for 2021 tax returns.
These schedules are used to report the pass-through entity’s items of international tax relevance, with Schedule K-2 being filed by pass-through entities reporting the pass-through’s total activity, and Schedule K-3 being provided to the owners with their share of the pass-through entity’s activity.
Many pass-through entities were surprised to learn that even though their entity did not have any foreign activity (or very limited activity), they still had to file Schedule K-2 and Schedule K-3 to report certain domestic information that may be applicable to their owners. As a result, the IRS issued guidance in February 2022 providing filing exceptions for 2021 Schedule K-2 and K-3 forms. These exceptions were welcome news for taxpayers and tax return preparers but understood to only apply for 2021 returns.
2022 Schedule K-2 & Schedule K-3 Domestic Filing Exception
On October 25, 2022, the IRS released draft Schedule K-2 and Schedule K-3 form instructions for partnerships filing Form 1065 (see further below for applicability to S corps). While there were several updates for 2022, one significant change was to include a new domestic filing exception. To qualify for the Schedule K-2 and Schedule K-3 filing exception, domestic partnerships must meet all four of the following requirements:
- The domestic partnership must have no or limited foreign activity (see below).
- All direct partners in the domestic partnership for the 2022 tax year are:
- Individuals who are U.S. citizens and/or resident aliens
- Domestic decedent’s estates that are not foreign estates, with solely U.S. citizen and/or resident alien individual beneficiaries,
- Domestic grantor trusts that are not foreign trusts, with solely U.S. citizen and/or resident alien individual grantors and beneficiaries, or
- Domestic non-grantor trusts that are not foreign trusts, with solely U.S. citizen and/or resident alien individual beneficiaries
- The partnership must notify all partners that it meets criteria 1 and 2 and will not be providing Schedule K-3 to the partners unless the partner requests the schedule. Partners must be notified no later than two months before the due date (without extension) for the filing of the partnership’s 2022 Form 1065. For tax year 2022 calendar-year partnerships, notifications must be sent to partners by January 15, 2023.
- No 2022 Schedule K-3 is requested by a partner on or before the “1-month date,” which is one month before the due date (without extension) for the filing of the partnership’s 2022 Form 1065. For tax year 2022 calendar-year partnerships, the 1-month date is February 15, 2023.
Should the partnership receive a Schedule K-3 request from a partner after the 1-month date (and no requests on or before the 1-month date), the partnership is not required to file Schedules K-2 or K-3 with the IRS or furnish Schedules K-3 to non-requesting partners, but is required to provide Schedule K-3 to the requesting partner(s) with the sections filled out that are requested by the partner(s).
If a partnership satisfies criteria 1 through 3, but not criteria 4 due to a partner requesting a Schedule K-3 on or before the 1-month date, the partnership must prepare Schedule K-2 and provide Schedule K-3 to the requesting partner(s), but only fill out the parts and sections for each schedule that are relevant to the requesting partner(s).
Foreign activity includes the following items (further defined in the instructions):
- Foreign income taxes paid or accrued
- Foreign source income or loss
- Ownership interest in a foreign partnership
- Ownership interest in a foreign corporation
- Ownership of a foreign branch
- Ownership interest in a foreign entity that is treated as a disregarded entity
To qualify as limited foreign activity under the exception, the foreign activity must be limited to:
- Certain passive category foreign income
- No more than $300 of foreign income taxes allowable as a credit under Section 901 are treated as paid or accrued
- Such income and taxes paid are shown on a payee statement to the taxpayer, e.g., a Form 1099
On November 4, 2022, the IRS released draft S corp Schedule K-2 and Schedule K-3 instructions. S corps are able to qualify for the same domestic filing exception. The rules are generally the same for S corps as partnerships, but there are only three criteria for S corps to qualify. The type of owner requirement is not necessary for S corps because the owners that would disqualify a partnership would not be eligible owners of an S corp (thus making that criteria unnecessary for S corps).
It is important to note that these are draft instructions and subject to change. IRS draft Schedules K-2 and K-3 form instructions for Form 8865, released October 27, 2022, do not contain a similar filing exception for foreign partnerships.
Many pass-through entities that were exempted under the 2021 exceptions may now have to file for 2022 as they may not meet the direct partner requirements as they have non-qualifying partners, e.g., a partnership or S corp partner. Unless further exceptions are provided in the final version of the instructions, pass-through entities that did not file Schedule K-2 or Schedule K-3 for 2021 should be preparing to file these schedules for 2022 returns.
While a pass-through entity may not meet the domestic filing exception, there may be other limited exceptions available, e.g., the Form 1116 exemption.
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