On December 2, 2022, the IRS issued new draft instructions for both Schedule K-2 and K-3 related to 2022 tax year compliance.
These new instructions, which are an update to a prior draft released in October, amend both the Domestic Filing Exception and Form 1116 Filing Exemption Exception to provide further leniency on who must complete the Schedule K-2 and K-3 in support of Form 1065 (U.S. Return of Partnership Income). While these instructions have been updated related to the Form 1065 only, we also expect a similar change to the instructions for Form 1120-S (Income Tax Return for an S Corporation).
Domestic Filing Exception
This exception focuses on the partnership or S Corporation providing notice to its partners or shareholders that no Schedule K-2 or K-3 will be provided. To qualify for this exception, the partnership or S Corporation must:
- Have no or limited foreign activity.
- Have only U.S.-filing individual partners (U.S. citizen/resident alien, certain trusts/estates, or S Corporation/LLCs with only one individual owner).
- Notify partners or shareholders that no K-3 will be provided by the time the K-1 is provided
- Receive no requests from a partner/shareholder no later than one month before the return is filed or one month before return due date.
This exception provides relief in completing the Schedule K-2 and K-3 for individual-owned partnerships and S Corporations that may not have previously used the information provided in completing their Form 1040. This exception does not grant relief to pass-through entities providing K-1s to other partnerships or corporations.
Form 1116 (Foreign Tax Credit) Filing Exemption Exception
This exception focuses on individuals providing notice to the partnership or S Corporation. To qualify for this exception:
- The pass-through entity must have no or limited foreign activity.
- All partners are not required to file a Form 1116.
- The partnership or S Corporation must receive notice that no K-3 is needed no later than one month before the return is filed or one month before the return due date.
While this exemption from filing the K-2 will only apply if all partners or shareholders do not need to file a Form 1116, this exception provides further flexibility. If not all partners provide notice of this exemption, the pass-through entity must still complete the Schedule K-2, but only provide a Schedule K-3 to the individuals who have not provided any notice of exemption.
These exemptions will provide some relief to taxpayers and tax preparers by relieving this compliance burden for simple partnerships and S Corporations with individuals not requiring this information. However, pass-through entities with foreign activity or with partnerships or corporate partners or shareholders will still be required to complete these schedules.