The IRS has issued draft instructions for partnerships and S corporations completing 2022 Schedules K-2 and K-3. According to Thompson Reuters these draft instructions add new exceptions to the requirement to file and furnish Schedules K-2 and K-3 for tax years beginning in 2022.
For tax years beginning in 2021, the IRS required pass-through entities (partnerships, S corporations and LLCs) with items of international tax relevance to complete Schedule K-2 and Schedule K-3 to report such items.
Schedule K-2, which is an extension of Schedule K (Form 1065 and Form 1120-S), is used to report items of international tax relevance from the operation of a partnership or S corporation.
Schedule K-3, which is an extension of Schedule K-1 (Form 1065 and Form 1120-S), is generally used by a pass-through entity to report to partners or shareholders their share of the items reported on Schedule K-2. Generally, partners and shareholders must include the information reported on Schedule K-3 on their tax or information returns.
The IRS was widely criticized by the tax community for how it handled these reporting requirements in 2021.
As A Result Of This Criticism, The IRS Provided Additional Exceptions To The Schedule K-2 And K-3 Filing Requirement; The Domestic Filing Exception And The Form 1116 Exception.
These exceptions are found in the filing instructions for Schedules K-2 and K-3.
Domestic Filing Exception. Partnerships and S corporations qualify for the domestic filing exception if they meet the following criteria:
- No or limited foreign activity. The instructions define foreign activity as (a) paying or accruing foreign income taxes; (b) foreign-source income or loss; (c) an ownership interest in a foreign partnership; foreign corporation; foreign branch or disregarded foreign entity.
A domestic partnership is considered to have limited foreign activity when (a) its only foreign activity is passive foreign income and the partnership paid or accrued no more than $300 of creditable foreign taxes on that income and (b) such income and taxes are shown on a payee statement (such as a Schedule K-1 from another partnership or a Form 1099 furnished or treated as furnished to the partnership.
- U.S. citizen or resident alien partners. During 2022, all a partnership's direct partners were (a) an individual who is a U.S. citizen or resident alien; (b) a decedent's estate that's not a foreign estate if all beneficiaries are U.S. citizens or resident alien individuals; (c) a domestic grantor trust if all beneficiaries and grantors are U.S. citizens or resident alien individuals; or (d) a domestic non-grantor trust if all beneficiaries are U.S. citizens or resident alien individuals.
- Partner/shareholder notification. Partnerships must notify their partners no later than two months before the due date (without extension) for filing the partnership's 2022 return that partners will receive a Schedule K-3 from the partnership only if the partner requests the schedule. For calendar year partnerships, this notification must be provided to partners by January 15, 2023. This notice can be provided electronically or by mail. S corporation shareholders must receive this notification no later than the date the S corporation furnished Schedule K-1 to the shareholder. The notice can be attached to the Schedule K-1 and should state that shareholders will not receive Schedule K-3 unless the shareholder requests schedule.
- No Schedule K-3 requests by the one-month date. The partnership or S corporation doesn't receive a request from any partner or shareholder for Schedule K-3 on or before the one-month date. The one-month date for calendar-year partnerships and S corporation for the 2022 tax year is February 15, 2023.
Form 1116 Exception. A domestic partnership that doesn't meet all the above requirements may still avoid filing Schedules K-2 and K-3 under the Form 1116 exception. The Form 1116 exception applies (1) if the partnership's partners are eligible for the Form 1116 exemption and (2) the partners notify the partnership that they are eligible for the exemption by the one-month date.
If only some of the partnership's partners notify the partnership that they are eligible for the Form 1116 exemption ("exemption notice"), the partnership doesn't need to complete the Schedule K-3 for those partners. However, the partnership must complete Schedules K-2 and K-3 for the other partners to the extent it doesn't qualify for the domestic.
If the pass-through entity doesn't meet the domestic filing exception because the creditable foreign taxes paid or accrued by the partnership are greater than $300, it may be advisable to have each partner state (in writing) whether they meet the Form 1116 exemption for the tax year. Partners meet the Form 1116 exemption if they had less than $300 of creditable foreign taxes paid or accrued for the tax year (or $600 for those filing as married filing jointly).
According to the instructions, a pass-through entity that doesn't receive an exemption notice from a partner or shareholder must presume such partner or shareholder would have to file a Form 1116 or Form 1118, Foreign Tax Credit (Corporations) to claim the credit. In this circumstance, the pass-through must complete Schedules K-2 and K-3, including Parts II and III, accordingly.
Practitioners with partnership and S corporation clients that may qualify for the domestic filing exception to filing Schedules K-2 and K-3 must send out notices to partners and shareholders no later than January 15, 2023.