IRS Schedules K-2 and K-3: Updated Filing Instructions for 2022
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Summary: Draft Instructions for Schedules K-2 and K-3 Recently Released
In December of 2022, the IRS released new draft Schedules K-2 and K-3 with instructions for Forms 1065, 1120-S and 8865. Once finalized by the Office of Budget Management (OMB), the revision will become applicable for a partnership’s 2022 tax period. The draft instructions contain multiple updates, with a significant change to the domestic exception that was previously available in the 2021 tax period.
Previous Rules for U.S. International Tax Reporting by Pass-through Entities
In 2021, the IRS released new Schedules K-2 (Partners’ Distributive Share Items – International; Shareholders’ Pro Rata Share Items – International) and K-3 (Partner’s Share of Income, Deductions, Credits, etc. – International; Shareholder’s Share of Income, Deductions, Credits, etc. – International) that included an expansion in the scope and level of detail required of U.S. international tax filing information.
Schedules K-2 and K-3, and any related attachments, are required for domestic or foreign partnership and S corporation taxpayers (those required to file Form 1065 (U.S. Return of Partnership Income), Form 1120-S (U.S. Income Tax Return for an S Corporation) and those required to file Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships) as part of their U.S. tax return) who have any item(s) of international tax relevance, including: direct or indirect foreign partner(s) or shareholder(s), foreign source income (FSI), foreign income taxes paid or accrued, and ownership in a foreign entity or foreign branch.
Prior to the release of Schedules K-2 and K-3, U.S. international tax information would be included as footnotes to the Schedule K-1 (Partner’s Share of Income, Deductions and Credits, etc.; Shareholder’s Share of Income, Deductions and Credits, etc.). The format and level of detail provided in these footnotes varied greatly between industries, taxpayers and tax preparers.
Schedules K-2 and K-3 standardize the format for reporting U.S. international tax information to the partners and shareholders of pass-through entities and provide clarity for partners and shareholders on how to calculate their U.S. income tax liability regarding international requirements. Items addressed on the Schedule K-2 and K-3 include items to determine foreign source income (FSI), which impacts a taxpayer’s eligibility to apply foreign tax credits (FTCs), details of foreign income taxes paid or accrued, amounts related to section 250 foreign-derived intangible income (FDII), items relevant to foreign partners, controlled foreign corporation (CFC) inclusion items (e.g., subpart F, global intangible low-taxed income (GILTI), investments in U.S. property) and other items.
Given the newness of Schedules K-2 and K-3 during the 2021 tax year and the comments provided to the IRS regarding the additional compliance burden imposed on the applicable taxpayers, the IRS for the 2021 tax year provided a broad exception from filing Schedules K-2 and K-3 with the IRS when:
- no direct partners or shareholders were foreign persons or entities;
- the partnership or S corporation had no foreign activity for the 2021 tax year;
- the partnership or S corporation did not report foreign activity on the 2020 tax year Schedule K or K-1;
- the partnership had no knowledge that partners were requesting this information.
This exception explicitly noted it was only available for the 2021 tax year returns.
New IRS Rules Applicable to the 2022 Tax Year
In December of 2022, the IRS provided an updated draft Schedules K-2 and K-3 and instructions for the Forms 1065, 1120-S and 8865 versions of these schedules. Once finalized by the Office of Budget Management (OBM), this set of revised instructions are intended to be applicable rules for the 2022 tax year and beyond. Among other revisions, the new draft instructions contain a domestic exception applicable for the 2022 tax year, although this revised exception is considerably more limited in scope than the 2021 version.
While the 2021 exception notes that no direct partners or shareholders may be foreign persons or entities, the 2022 exception provides that in addition to the limited or no foreign activity requirement, all partners or shareholders must be either:
- U.S. citizens;
- U.S. resident aliens;
- Domestic descendant’s estates in which all beneficiaries are U.S. citizens or U.S. resident aliens;
- Domestic grantor trusts in which all grantors and beneficiaries are U.S. citizens or U.S. resident aliens;
- Domestic non-grantor trusts in which all beneficiaries are U.S. citizens or U.S. resident aliens;
- S corporations with a sole shareholder;
- Single-member LLCs, where the LLC’s sole member is one of the persons listed above, and the LLC is disregarded as an entity separate from its owner.
Most importantly, based on the draft instructions the domestic exception is not available for taxpayers with owners that are S-corporations with multiple shareholders, domestic partnerships or domestic corporations. This change in exception rules may create a considerable compliance burden on tiered partnership structures.
In addition, the 2022 exception includes a requirement that, should the 2022 exception be met, the partnership or S corporation must notify its partners or shareholders that no Schedule K-3 information will be provided (unless requested) no later than when the partnership or S-corporation furnishes the Schedule K-1 to the partner or shareholder. The notification may be included as an attachment to the Schedule K-1.
Partners and shareholders have until one month prior to the return due date, not including extensions (Feb. 15 for calendar year entities) to timely request Schedule K-3 information. If a timely request is made, Schedules K-2 and K-3 must be completed and filed with the IRS in relation to the requesting partners or shareholders (and provided to the requesting partner or shareholder). If a partner or shareholder requests Schedule K-3 information outside of this timeframe, Schedule K-3 information must still be provided to the partner or shareholder, but this information is not required to be provided to the IRS.
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