IRS Updates Draft K-2 & K-3 Instructions
The IRS released updated draft instructions for 2022 Schedule K-2 and K-3 filings on December 2, 2022 for partnerships and on December 5, 2022 for S corporations. These updates made significant changes to the domestic filing exception that was introduced with the first set of draft instructions. Our FORsights™ article, “IRS Provides 2022 Schedule K-2/K-3 Domestic Filing Exception,” addressed the first set of draft instructions.
The primary changes made to the domestic filing exception in the new draft instructions are listed below:
- Pass-through entities can notify the owners that they will not be receiving a Schedule K-3 for 2022 by including a statement with each owner’s Schedule K-1.
- This removes the burden of the entity having to notify the owners by the 2-month date, e.g., by January 15, 2023 for calendar year 2022 filers.
- One qualification for the exception was that no owner contacts the entity prior to the 1-month date requesting a Schedule K-3. This 1-month date was changed to be one month before the 2022 pass-through return is filed. For example, August 15, 2023 would be the latest “1-month” date for a calendar year 2022 pass-through filer assuming they filed on September 15, 2023 (the final due date including extensions).
- The list of qualifying owners was expanded for partnerships to include S corps that have only one owner and single-member LLCs that are disregarded for income tax purposes and whose sole member is a qualifying owner for purposes of the exception.
- S corps do not have a qualifying owner requirement for purposes of the domestic filing exception.
The remainder of this article will summarize the updated rules for the domestic filing exception as included with the second round of draft 2022 instructions.
2022 Schedule K-2 & Schedule K-3 Domestic Filing Exception
To qualify for the Schedule K-2 and Schedule K-3 domestic filing exception, domestic partnerships and S corps must meet all* of the following requirements:
- The domestic pass-through entity 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
- Domestic nongrantor trusts that are not foreign trusts, with solely U.S. citizen and/or resident alien individual beneficiaries
- S corps with a sole shareholder
- Single-member LLCs that are treated as disregarded entities for income tax purposes, where the type of sole owner is listed in this group above
- *Note: S corps do not have an ownership requirement criterion for this exception.
- The pass-through entity must notify all owners that it meets criteria 1 and 2 and will not be providing Schedule K-3 to the owner unless the owner requests the schedule. Notification may be made with a statement included on the Schedule K-1 provided to the owner.
- No 2022 Schedule K-3 is requested by an owner on or before the “1-month date,” which is one month before the pass-through entity return is filed. For tax year 2022 calendar-year entities, the latest 1-month date is August 15, 2023 if the entity files an extension and files the return on September 15, 2023.
Should the pass-through entity receive a Schedule K-3 request from an owner after the 1-month date (and no requests on or before the 1-month date), the entity is not required to file Schedules K-2 or K-3 with the IRS or furnish Schedules K-3 to nonrequesting owners, but is required to provide Schedule K-3 to the requesting owner(s) with the sections filled out that are relevant to the requesting owners(s).
If a pass-through entity satisfies criteria 1 through 3, but not criteria 4 due to an owner requesting a Schedule K-3 on or before the 1-month date, the entity must file Schedule K-2 and Schedule K-3 for the requesting owner(s) with the IRS, but only fill out the parts and sections for each schedule that are relevant to the requesting owner(s). The entity must provide Schedule K-3 to the requesting owner(s) as well.
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
It is important to note that these are draft instructions and are 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 nonqualifying partners, e.g., a partnership or corporate 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 exception.
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