Pass-through entities are generally not taxed at the entity level, but instead, the profits and losses of the entity flow through to the partners, who report this information on their individual tax returns. Beginning with the 2021 tax year, domestic partnerships, S corporations, and limited liability corporations taxed as a partnership (pass-through entities) were required to file the new K-2 and K-3 schedules with their tax return.
Schedule K-2 reports items of international tax relevance and replaces certain portions of prior versions of Schedule K. This form requires greater detail and includes information regarding each partner’s foreign tax credit, foreign-derived intangible income (FDII), global intangible low-taxed income (GILTI), and Base Erosion and Anti-Abuse Tax (BEAT).
Schedule K-3 reports a partner’s distributive share of items of international tax relevance and is an extension of Form 1065 Schedule K-1. Schedule K-3 provides information for partners and shareholders about their respective shares of items reported on Schedule K-2.
The problem is that the requirement for Schedules K-2 and K-3 created an undue burden for many pass-through entities with limited or no foreign activity. To help reduce this burden, the IRS announced a new filing exception for the 2022 tax year that allows domestic partnerships and S corporations to skip the completion and filing of Schedules K-2 and K-3 under certain circumstances.
New filing exception
The IRS has announced a new filing exception for the tax year 2022, allowing domestic partnerships to not file Schedules K-2 and K-3 with the IRS or provide the schedules to partners under certain circumstances. The following criteria must be met to qualify:
1. No or limited foreign activity. The partnership must have no foreign activity or only limited foreign activity in 2022. Limited foreign activity is defined as passive category foreign income, which generates no more than $300 of foreign income taxes eligible for foreign tax credit and is shown on a payee statement issued by the partnership.
2. Rules for direct partners during the tax year. All direct partners during the 2022 tax year must be U.S. citizens or resident aliens. The presence of an entity as a partner would disqualify the partnership from the general filing exception, except in cases where the entity is an S corporation with a sole shareholder or a single-member disregarded LLC with an owner who is either a U.S. citizen or resident alien. Domestic estates and trusts are allowed as partners if the beneficiaries are U.S. citizens or resident aliens.
3. Partner notification. If a partnership satisfies both criteria (1 and 2), it must notify its owners that it will not provide Schedule K-3 unless requested. The notification can be provided as an attachment to Schedule K-1.
4. No Schedule K-3 requests by the 1-month date. If the entity does not receive a request from any of the partners on or before one month before the due date of the partnership’s Form 1065 and meets all the aforementioned criteria, it will not have to file a Schedule K-2 or K-3 with the IRS.
If the entity receives one or more requests for the K-3 by the deadline, then the entity must complete Schedules K-2 and K-3 in relation to the requesting partner(s).
A partner may still request a Schedule K-3 after the deadline. In such a case, the partnership would need to provide the requesting partner with a copy of the Schedule K-3 no later than the date the entity return is filed or one month from the date of request, whichever is later. However, the entity is not required to file Schedule K-3 with the IRS.
The Schedule K-2 / K-3 exception for an S corporation is similar to that of a partnership, except for the rules on direct partners (#2).
This article is intended to provide a brief overview of the new Schedule K-2 and K-3 filing exceptions and is not a substitute for speaking with one of our expert advisors. Please contact our office for more information on the Schedules K-2 and K-3 exception.