IRS Introduces a Domestic Filing Exception to Schedules K-2 and K-3

Background

The Internal Revenue Service (IRS) introduced Schedules K-2 and K-3 beginning with tax year 2021. Schedule K-2 (Partners’ Distributive Share Items−International) and Schedule K-3 (Partner’s Share of Income, Deductions, Credits, etc.−International) replaced and expanded reporting requirements for international tax items in an effort by the IRS to expand and streamline the presentation and level of detail provided with respect to U.S. international tax information. Such international items previously were included as footnotes to Schedules K and K-1.

These schedules accompany Forms 1065 (partnerships), 1120-S (S corporations), and 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships), (together, flow-through entities). Any flow-through entity that is required to file Form 1065, 1120-S, or 8865 and that has items that are relevant to the determination of U.S. tax or certain withholding or reporting obligations of its partners or shareholders must file the Schedules K-2 and K-3. Importantly, a flow-through entity with no foreign source income, no assets generating foreign source income, no foreign partners, or no foreign taxes paid or accrued might still need to report information on Schedules K-2 and K-3. 

In the final instructions for the Schedules K-2 and K-3 for the 2022 tax year that were published recently, the IRS added an important exception to the requirements for filing Schedules K-2 and K-3 with respect to domestic filing (domestic filing exception) for both partnerships and S corporations.

The Domestic Filing Exception - Overview

Under the exception, a domestic partnership is not required to complete and file Schedules K-2 and K-3, or provide Schedule K-3 to its partners (except if requested to by a partner, as further described below), if each of the below four criteria are met for the tax year:

1. The filing partnership has no foreign activity or has foreign activity that is limited to passive income generating no more than $300 of foreign taxes that are eligible for foreign tax credit;
2. During tax year 2022, all of the direct partners of the filing partnership are individuals that are U.S. citizens or residents, domestic decedent’s estates and trusts with solely U.S. citizen and/or resident individual beneficiaries, S corporations with a sole shareholder, or disregarded single-member LLCs where the LLC’s sole member is one of the persons listed above;
3. The partners received a notification from the partnership stating that partners will not receive Schedule K-3 from the partnership unless the partners request the schedule. Such notification must be furnished at the latest when the partnership furnishes the Schedule K-1 to the partners; and
4. The partnership does not receive a request from any partner for Schedule K-3 information on or before a date that is one month before the date the partnership files the Form 1065 (the one-month date). For tax year 2022 calendar year partnerships, the latest one-month date is August 15, 2023, if the partnership files an extension.

The Schedule K-2 and K-3 instructions note that, if a partnership receives a request from a partner for the Schedule K-3 information after the one-month date, while the domestic filing exception is met and the partnership is not required to file the tax year 2022 Schedules K-2 and K-3 with the IRS or furnish the tax year 2022 Schedule K-3 to the non-requesting partners, the partnership still is required to provide the tax year 2022 Schedule K-3 to the requesting partner. Such schedule must include the requested information and be provided on the later of the date on which the partnership files the Form 1065 or one month from the date on which the partnership receives the request from the partner. Further, the partnership must complete and file tax year 2023 Schedules K-2 and K-3 with respect to the requesting partner by the tax year 2023 Form 1065 filing deadline.

These same general rules apply for S corporations and their shareholders. 

Observations

While this domestic filing exception is an important exception it is narrower than what many have hoped for, as the exception is not extended to partnerships with direct partners who are domestic corporations or domestic partnerships (i.e., tiered partnerships). Therefore, it is likely that the domestic filing exception will apply to many fewer domestic partnerships than hoped.

Partnerships that wish to take advantage of this exception need to analyze each criteria, and obtain and retain the proper documentation in order to take advantage of the exception. In particular, in connection with the one-month date, partnerships will need to monitor closely requests from its partners for Schedule K-3 and their timing compared to the expected filing date. As indicated above, even if a request arrived after the one-month date and the partnership otherwise meets the other three criteria, the partnership would still be required to provide a Schedule K-3 to the requesting partner.

For questions about the domestic filing exception or any other tax issues, please contact a member of Ballard Spahr’s Tax Group.

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