Effective for tax year 2021, the IRS introduced K-2 and K-3 Schedules as part of Form 1065 (U.S. Return of Partnership Income) and Form 1120S (U.S. Income Tax Return for an S Corporation) to make federal income tax liability more transparent for partners who share ownership in certain pass-through entities. Prior to the release of K-2 and K-3 Schedules, many partners and shareholders lacked an accurate understanding of their tax obligations. As a result, they found it difficult to determine their individual filing requirements, available foreign tax credits and if any additional taxes were owed in the U.S.
The initial K-2 and K-3 partnership instructions (applied for tax year 2021) provided a limited Domestic Filing Exception (DFE), with additional exceptions and guidance released on February 16, 2022 (FAQ 15). What came as a surprise to many taxpayers was the requirement to file Schedules K-2 and K-3 even if they had no foreign activity. The K-2 and K-3 is now mandatory for all Partnerships and S Corporations unless you can qualify for exemption under the DFE. On December 23, 2022, after several drafts, the IRS finalized the Partnership and S Corporation instructions for Schedules K-2 and K-3 for tax year 2022 with updated DFE. The DFE provides an exception to filing for solely domestic entities. The purpose is to identify businesses that do not need to include these new schedules on their tax returns because their owners do not have a need for the information on their personal returns.
Partnership Instructions for Domestic Filing Exception (DFE) for tax year 2022 requires:
To be exempt from filing Schedules K-2 and K-3, partnerships must satisfy the following four tests:
- No or limited foreign activity.
- The partners of the partnership are limited to U.S. citizens, individual resident aliens, domestic decedent estate, domestic grantor trust, domestic non-grantor trust, S-Corp with sole owner, and SMLLC with sole owner.
- Written notice has been provided to the partners that they will not receive Schedule K-3 unless the partner requests the schedule.
- The partnership did not receive a request for Schedule K-3 from any partner one month prior to filing the Form 1065.
In addition to the Domestic Filing Exception (DFE), a Form 1116 (claiming foreign income) Exemption applies to the new schedules. If all of the partners or shareholders do not qualify for this exemption, the entity is required to file the Schedules K-2 and K-3, but only as it relates to the owners that do not qualify.
For 2022, penalty relief for taxpayers who exercise good faith is no longer applicable. The relief had been provided in FAQ 10 and notice 2021-39 to ease the original transition period. Now that relief has been rescinded, taxpayers should expect penalties to be assessed if Schedule K-2 and K-3 are not completed in their entirety when required, or if the schedules are not completed and furnished to the respective partners and shareholders in the specified time limits.
The IRS’ narrower exceptions to filing schedules and the removal of penalty relief means Partnerships and S Corporations should anticipate that Schedules K-2 and K-3 will more than likely be required to be prepared for tax year 2022.
The new K-2 and K-3 Schedules for applicable owners of passthrough organizations have been the subject of much discussion in the tax community and amongst business owners as the new schedules are much lengthier than the single line items in the Partnership and S Corporation tax return and K-1 Schedule. This means that many partners and shareholders now need to report information they may not have previously quantified or provide information in much greater detail.
For a more information, or assistance with filing Schedules K-2 and K-3, please reach out to our CSH International Tax experts.