IRS Offers Limited Relief from Filing Schedules K-2 & K-3 for Certain US Partnerships and S Corporations

At a glance

• The main takeaway: On October 25, 2022, the IRS issued draft instructions for Schedules K-2 and K-3, which clarifies an exception from filing if a partnership consists solely of US partners and had “no or limited foreign activity” in its tax year. However, the relief imposes duties upon the partnership and its managing partner/tax representative before claiming the exception, and partners or LLC members may still request a Schedule K-3 by notifying the partnership representative.
• Impact on your business: Partnerships (including LLCs taxed as partnerships) and S corporations that meet the no-foreign-partners or shareholders, and no-or-little-foreign-activity tests and wish to opt out of filing Schedules K-2 and K-3, must provide notice to all partners/members of this intent to give partners or shareholders the opportunity to request a K-3. If no partner or shareholder responds to request a schedule, at least one month prior to the date the tax return is filed (no later than August 15, 2023 for the 2022 tax year), then the company is not required to file either Schedules K-2 or K-3 with the IRS. However, the company may be required to prepare a Schedule K-3 for any partner or shareholder who requests the schedule after the earlier date of when the return is filed, or August 15, 2023.
• Next steps: If you are the partnership representative or LLC managing member, you should be aware of the required deadlines for notifying partners/members of your intent to claim this “domestic filing exception.” Your Aprio tax advisor can help you navigate the specifics of determining whether your partnership/LLC is eligible for the exception and provide guidance on making the required notifications to shareholders.

Schedule a consultation with an Aprio Tax Adviser Today.

The full story:

Beginning with the 2021 tax year, all US partnerships and limited liability corporations (LLCs) taxed as partnerships were required to complete and file new Schedules K-2 and K-3 with their Form 1065 Income Tax Return. According to the IRS, the new schedules were designed to assist partners in calculating their income tax liability or in identifying deductions, credits, or other tax attributes arising from partnership business or investment activity offshore by standardizing the format for tax reporting of items of “international tax relevance from the operation of the partnership.”

While most of the information called for by the new schedules were already required to be included in footnotes or other supplemental attachments to a partner’s K-1, the new forms still created significant information gathering burdens and additional tax compliance expense. Further, because the IRS required all partnerships filing Form 1065 tax returns to complete and file the new schedules, including furnishing copies of the K-3 to all partners, many partnerships without foreign ownership or activity incurred these additional costs and compliance burdens unnecessarily.

The IRS had previously discussed a prior exception to the Schedules K-2 and K-3 filing requirements in a set of Frequently Asked Questions (FAQs) issued throughout early 2022. However, those responses did not provide practitioners with any firm guidance or safe harbor under which taxpayers would be protected from potential penalties arising from delinquent or incorrect schedules.

In response to feedback from practitioners and professional organizations, the IRS promised in mid-2022 to address the administrative burden created by requiring all partnerships to file Schedules K-2 and K-3, without regard to their level of foreign involvement or activity. The draft instructions to the schedules, issued in October 2022 and updated in December, represent the Treasury’s efforts to mitigate those burdens for taxpayers with solely domestic activities and ownership.

The October 2022 draft instructions create a “domestic filing exception” to K-2 and K-3 filing requirements

The draft instructions reiterate the default rule, that all entities taxed in the US as partnerships must file the schedules if the entity “has items relevant to the determination of the US tax or certain withholding tax or reporting obligations of its partners under the international provisions of the Internal Revenue Code.”

The IRS frequently releases draft instructions for certain key tax forms, particularly in circumstances where the format, or type of information required by a particular form involves changes from prior years’ filings. The 2022 tax year draft instructions for Schedules K-2 and K-3 follows this practice.

The draft instructions then go on to create a “domestic filing exception” for Schedules K-2 and K-3, listing four eligible criteria a partnership must meet to avoid the requirement. To be eligible for the domestic filing exception, a partnership must:

1. Have no or limited foreign activity: The instructions define what constitutes “foreign activity,” specifically listing foreign income taxes paid or accrued, foreign source income or loss, entity ownership in a foreign partnership, corporation, disregarded entity, or legal branch. The instructions further list the thresholds which would qualify as “no or little,” specifying that partnerships with only passive category foreign income, and/or less than $300 of foreign income taxes paid or accrued and allowable as a foreign income tax credit, fall under the “little activity” criteria for the filing exception.
2. Consist entirely of US citizen or resident alien partners: Partnerships and S corporations (which already are precluded from having non-resident shareholders) must be owned entirely by US citizens or resident aliens to qualify for the domestic filing exception. Eligible shareholders include domestic decedents’ estates, domestic grantor trusts and domestic non-grantor trusts.
3. Notify all partners or S corporations of the company’s intent to not file Schedules K-2 and K-3: Any partnership or S corporation qualifying under tests (1) and (2), listed above, that elects to not file or furnish a Schedule K-2 or Schedule K-3 to the IRS, must notify its partners or shareholders that they will not receive a Schedule K-3 from the company unless the partner or shareholder requests the schedule.
4. Not receive any written request from a domestic partner to provide a Schedule K-3: If no partner requests a Schedule K-3 by the deadline, one month prior to the  date  the return is filed, and the partnership meets the other eligibility criteria for the exception, then the partnership will not be required to file Schedules K-2 or K-3.

Unfortunately, the news regarding the domestic filing exception is not all good since a partnership or S corporation, which otherwise meets the exception, may still need to complete Schedules K-2 and K-3 if a partner requests because the partner claims a foreign tax credit and may need certain information to do so. Further, the draft instructions specify that partnerships that are otherwise eligible for the exception may still be required to file the schedules if it made deductible payments to foreign parties related to any of its domestic corporate partners for purposes of base erosion and anti-abuse tax (BEAT) compliance.

Filing requirements if a partner or shareholder requests a Schedule K-3

• If the partnership or S corporation receives a request from a partner for Schedule K-3 information on or before the one-month deadline, the partnership must file Schedules K-2 and K-3 with the IRS and must provide the Schedule K-3 to the requesting partner only. When completing the schedules in response to a partner’s timely request, the partnership completes the Schedules K-2 and K-3 to report only the information relevant to the requesting partner. No other parts or sections are required, and the partnership is not obligated to complete, file, or provide any other parts of the schedules to either the IRS, the requesting partner, or any non-requesting partner.
  
• If a partnership or S corporation does not receive a request from a partner prior to the one month-deadline but receives a request from a partner after the deadline, the partnership will be deemed as meeting the domestic filing exception and is not required to file either Schedule K-2 or K-3 with the IRS. However, the partnership receiving such a non-timely request prior to filing its 1065 Income Tax Return is required to provide the requesting partner with a Schedule K-3 on the later of either the date the income tax return is filed, or one month after the request is received by the partnership.

In cases where a partnership receives both timely and non-timely requests for Schedules K-2 and K-3, the partnership or S corporation is not obligated to include any information pertaining to the non-timely requesting partner on its K-2 or K-3 filings with the IRS.

However, any partnership or S corporation that receives a request from a shareholder for a Schedule K-3 for the 2022 tax year is precluded from claiming the domestic filing exception for the 2023 tax year, and must prepare, file and furnish both schedules with respect to the requesting partners or shareholders only.

The bottom line

The draft instructions released by the IRS provide the possibility of relief from the extra information gathering burden and increased costs of preparing and filing Schedules K-2 and K-3 for eligible domestic partnerships and LLCs. However, the steps to obtain that relief require partnerships and their representatives or managing members to make sure they meet notification requirements to partners. Aprio’s Tax Advisors are closely following the impact and specifics of this new relief and can help you determine whether you or your company may avoid the extra burden of these foreign-related partnership Schedules K-2 and K-3.

Related Resources/Assets/Aprio.com articles/pages

Partnerships and S Corporations: What to Expect from Schedules K-2 and K-3 

K-1 Instructions 

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