Update: Hold On to Your Seats: More Changes to the Schedule K-2/3 Rollout!
The IRS released a newer draft of the Schedule K-2/3 instructions. These draft instructions modify the Domestic Filing Exception, which is the exception from filing that many domestic-only partnerships were looking to invoke (see more information below). The previous instructions required Partnerships to notify partners by January 15, 2023, that they would not provide them with a Schedule K-3. The revised draft, dated December 2, 2022, modifies that requirement allowing partnerships to notify their partners at the latest when the Schedule K-1 is issued to partners. Furthermore, it allows this notification to be done as an attachment to the Schedule K-1. These instructions are still in a draft format, so the IRS may make further changes; however, this is a welcome change in the rules to many partnerships who were preparing to undertake the monumental task of notifying their partners by January 15, 2023.
Stay tuned for more Schedule K-2/3 updates.
Original Publish Date: November 10, 2022
Schedules K-2 and K-3 were introduced by the IRS during the 2021 filing year. The forms were intended to provide additional information to taxpayers regarding reporting of foreign activities and specifically to provide more detailed information for taxpayers to correctly calculate their foreign tax credits.
Schedule K-2 reflects the overall information for the partnership and Schedules K-3 result from the Schedule K-2 and are distributed to each partner in the partnership with their specific information along with their Schedule K-1.The IRS released an early draft of updated instructions for Schedules K-2/K-3 on October 25, 2022 for the upcoming filing year. The updates include clarification of reporting for ownership of foreign entities and new exceptions to filing requirements.
In good news, the IRS has introduced a “Domestic Filing Exception.” The exception from filing is applicable if the following four criteria are met:
- The partnership had no or limited foreign activity;
- All partners are U.S. Persons;
- All partners are notified within two months prior to the due date of the return without extension (January 15) that they will not receive a Schedule K-3; and
- The partnership does not receive any requests for a Schedule K-3 by the “1-month date” (February 15).
The final criteria above provides partners an opportunity to request a Schedule K-3 up to one month prior to the due date. If the return is due on March 15 the partners have until February 15 to request the information. If there is a timely request, the partnership only needs to provide that specific partner with the Schedule K-3 and submit copies to the IRS. If the request is late, the partnership is still required to provide the Schedule K-3 to the partner, but the partnership is not required to submit the filing to the IRS.
Finally, partnerships can still utilize the Form 1116 Exemption Exception. This allows a partnership that is required to file Schedules K-2 and K-3 to omit the sections related to the Foreign Tax Credit. Notification from all of the partners must be received one month before the due date of the return for the partnership to take advantage of this exception.
With the recent changes, we expect fewer Schedule K-2 and Schedule K-3 requirements; however, partnerships will still need to analyze which filing exception(s) may apply and obtain the proper documentation to take advantage of those exceptions. Please reach out for clarification on filing requirements, as failure to file and prepare correctly can incur penalties. The IRS will not be granting a good faith effort exception on the preparation of these forms for 2022.
In addition to the “Domestic Filing Exception”, the partnership does not need to attach Form 8858 for Foreign Disregarded Entities to its Schedule K-3. Regarding forms such as Form 5471 for Foreign Corporations and Form 8621 for Passive Foreign Investment Companies, partnerships are still required to attach these if the information is relevant to its partners, meaning they will need the information to prepare their returns.
For more information on this topic, please contact a member of Withum’s International Services Team.