15 Dec Schedules K-2/K-3 Draft Instructions Released (12-07-2022)
The IRS has created another filing exception for domestic entities.
The IRS released the 2022 draft partnership and S corporation instructions for Schedules K-2 and K-3, which contain a new domestic filing exception. The exception states that partnerships and S corporations are not required to complete Schedules K-2 and K-3 if:
- They have no or limited foreign activity;
- All partners are U.S. citizens or resident aliens (the S corporation instructions do not contain this requirement);
- The partnership or S corporation sends specific notification to the partners/shareholders by January 15 (calendar-year taxpayers); and
- No partners/shareholders specifically request Schedule K-3 from the entity by February 15 (calendar-year taxpayers).
The S corporation instructions do not specifically contain the requirement that S corporation shareholders be U.S. citizens or resident aliens. This is likely because an S corporation cannot have shareholders who are not U.S. citizens or resident aliens.1
The new exception only applies to domestic partnerships and S corporations, which are defined as those that are created or organized in the United States or under the law of the United States or any state.2
No or limited foreign activity
The domestic filing exception requires that partnerships and S corporations have no foreign activity or very limited foreign activity. No foreign activity means that the entity does not have any of the following:
- Foreign income taxes paid or accrued (except as noted immediately below);3
- Foreign-source income or loss (except as noted immediately below);4
- Ownership interest in a foreign partnership;5
- Ownership interest in a foreign corporation;6 or
- Ownership interest in a foreign entity that is treated as a disregarded entity.7If the entity has foreign activity, then it still meets the exception for filing Schedules K-2 and K-3 if the foreign activity is limited to:
- Passive category foreign income (determined without regard to the high-taxed income exception under IRC §904(d)(2)(B)(iii));
- Upon which not more than $300 of foreign income taxes allowable as a credit under IRC §901 are treated as paid or accrued by the partnership; and
- Such income and taxes are shown on a payee statement8 that is furnished or treated as furnished to the partnership (such as a Form 1099-DIV and K-1s received from other passthrough entities).
All partners are U.S. citizens or resident aliens
The domestic filing exception requires that all the direct partners in the domestic partnership must be:
- Individuals who are U.S. citizens;
- Individuals who are resident aliens;9
- Domestic decedents’ estates with solely U.S. citizen and/or resident alien individual beneficiaries;10
- Domestic grantor trusts11 that are not foreign trusts12 and that have solely U.S. citizen and/or resident alien individual grantors and solely U.S. citizen and/or resident alien individual beneficiaries; or
- Domestic nongrantor trusts13 with solely U.S. citizen and/or resident alien individual beneficiaries.
Partnerships are only required to look to their direct partners to determine if they meet the domestic filing exception. Direct partners are those that actually receive a K-1 from the partnership.
The list of eligible partners does not include any entities other than domestic trusts and estates. As such, if a partnership has even one direct partner that is another partnership, corporation, or LLC, then the partnership cannot meet the domestic filing exception for Schedules K-2 and K-3.
The draft instructions do not mention disregarded entities. Because disregarded entities such as single member LLCs are treated as individuals for federal income tax reporting purposes, it is possible they could qualify as individuals. Hopefully, the IRS will clarify this point in their final instructions or in supplemental guidance, such as FAQs posted to their website.
The domestic filing exception requires that each partner/shareholder must receive a notification from the partnership or S corporation, either electronically or by mail, dated no later than two months before the due date (without extension) for filing the entity’s Form 1065/1120S for the year. The notification must state that the partners/shareholders will not receive a Schedule K-3 from the partnership or S corporation unless the partners/shareholders request the schedule.
Two months before the due date for calendar-year Forms 1065 and 1120S is January 15.
The draft Schedule K-2/K-3 instructions require that the notification:
- Must be received by the partner/shareholder by January 15;
- Can be sent either electronically (including by e-mail) or by mail; and
- Must state that the partners/shareholders will not receive a Schedule K-3 unless the partners/shareholders request it.
Partner/shareholder request for Schedule K-3
If a partner/shareholder requests Schedule K-3 from the partnership or S corporation one month before the due date (without extension) of the entity’s Form 1065/Form 1120S, then the entity must file Schedules K-2 and K-3 with the IRS and furnish a copy of the Schedule K-3 to the requesting partner/shareholder. One month before the due date for calendar-year Forms 1065/1120S is February 15.
The Schedules K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting partner/shareholder.
If the partner/shareholder requests the K-3 after February 15, the partnership or S corporation is not required to file the K-2 and K-3 with the IRS but must provide the requesting partner/shareholder with the K-3 by the later of:
- The date on which the entity files its Form 1065 or Form 1120S; or
- One month from the date the partnership or S corporation receives the partner’s request.
|Example of partner request for Schedule K-3:
The JJ Partnership has two equal partners, Joy and Jan, both of whom are domestic partners. The partnership received $290 of creditable foreign income paid or accrued on Form 1099-DIV. The partnership does not have any other foreign activity.
The partnership e-mailed notification to its partners by January 15, 2023, that it will not prepare Schedule K-2 nor issue Schedule K-3 to its partners unless it receives a request for Schedule K-3 from a partner by February 15, 2023.
Jan e-mailed the partnership on February 11 notifying it that she wants a copy of Schedule K-3.
The partnership must prepare Schedule K-2 and provide a copy of Schedule K-3 to Jan when it completes the partnership income tax return for the 2022 tax year. When preparing the Schedules K-2 and K-3, the partnership does not need to complete, attach, or file any parts or sections relevant to Joy.
If, however, Jan e-mailed the partnership on February 16 (one day after the one-month deadline) notifying it that she wants Schedule K-3, then the partnership is not required to file either Schedules K-2 or K-3 with the IRS, but it must provide Jan with Schedule K-3 containing the requested information.
Form 1116 exemption exception
In addition to the domestic filing exception, domestic partnerships and S corporations are not required to complete Schedules K-2 and K-3 if all partners/shareholders are eligible for the Form 1116, Foreign Tax Credit, filing exemption and if the partnership or S corporation receives notification of the partners’/shareholders’ eligibility for such exemption by the date that is one month before the entity’s filing deadline (not including extensions) (February 15, 2023, for calendar-year partnerships and S corporations).
If the partnership or S corporation receives notification from only some of the partners/shareholders that they are eligible for the Form 1116 exemption, then the entity need not complete Schedules K-3 for those exempt partners/shareholders but must complete the Schedules K-2 and K-3 with respect to the other partners/shareholders to the extent that the entity does not qualify for the domestic filing exception.
Form 1116 filing exemption
Not all partners and shareholders who might be eligible for the Foreign Tax Credit will actually file Form 1116. Individuals who have less than $300 ($600 MFJ) in creditable foreign taxes paid on qualified passive income may elect to claim the credit without filing Form 1116. The election out of filing Form 1116 is only available to individual taxpayers.
The individual can only make the election if they receive the information regarding the foreign taxes on a payee statement (e.g., Form 1099-DIV). Taxpayers who make the election cannot claim any credit carryovers.