Since their initial release in 2021, Forms K2 and K3, used to report international tax items, have created an expanded compliance burden for many pass-through entities, including those with little to no foreign activity to report. To help mitigate these burdens, the IRS has introduced multiple filing exceptions, the biggest of which is the domestic filing exception. The IRS has continued to expand this exception to include more pass-through entities that qualify, reducing this compliance burden.
Tax Year 2025 Changes
For the 2025 tax year, the IRS has released the following changes regarding the ownership requirements of pass-through entities looking to claim the domestic filing exception:
- Pass-through entities with S corporations as shareholders are now allowed to claim the exception.
- Previously, only S corporations with a sole individual shareholder were eligible.
- Pass-through entities with upper-tier partnerships as shareholders that themselves only have certain domestic shareholders can now claim the exception.
- For example, the upper-tier partnerships themselves must have shareholders that are on the approved list below, except for other partnerships.
Why is this significant?
Certain tiered pass-through entities may now claim the domestic filing exception for all tiers if the upper-tier shareholders meet the ownership criteria outlined below and the pass-through entity has minimal to no foreign activity, as described in the exception instructions.
For example, individuals in a rental real estate partnership with both a general partner and a limited partner owned by individuals would now qualify for the domestic activity exception. An entity structure like an S corporation with multiple members owning partnerships would also qualify.
Domestic Filing Exception Criteria
Below is the full, updated criteria for the domestic filing exception for tax year 2025:
- No or limited foreign activity: During the pass-through entity’s 2025 tax year, the entity has no or limited foreign activity
- Any foreign income is limited to the passive category foreign income, and not more than $300 of foreign income taxes allowable as a foreign tax credit has been paid.
- Any ownership of a foreign entity, such as a foreign partnership, corporation, disregarded entity or branch, automatically counts as having foreign activity.
- United States citizen/resident alien partners: All partners of the pass-through entity must be one of the following:
- United States citizens
- United States resident aliens
- Domestic decedents’ estates with solely United States beneficiaries
- Domestic grantor trusts with solely United States grantors and beneficiaries
- Domestic non-grantor trusts with solely United States beneficiaries
- S corporations
- Single-member LLCs
- These LLCs must be disregarded as separate from their owners and be owned by one of the entities listed in letters a-f.
- Domestic partnerships with direct partners who are any of the entities listed in letters a-g
- Multi-tiered structures where a partnership shareholder has partnerships as shareholders would not qualify for the domestic activity exception.
- Partner notification: Partners must receive notification of said exception being claimed at the latest when the Schedule K-1 is provided to the partner.
- No 2025 Schedule K-3 requests by the one-month date: The pass-through entity cannot receive a K-3 request from a partner by the one-month date, which is one month before the date the entity files its return.
This expanded domestic filing exception should be beneficial to those with pass-through entities that have S corporations and certain partnerships. It is important to note, however, that verification of the owners of these upper-tier partnerships should be obtained and recorded in the workpapers of these entities. If at any point one of the upper-tier partnerships in the ownership structure has an entity as an owner that is not listed above, the bottom-tier pass-through entity still cannot claim the domestic filing exception.
RKL’s International Tax team will help you navigate these changes in Forms K2 and K3. Contact your advisor today.
