Partnerships and S Corporations: IRS Clarifies Schedule K-2 and K-3 Rules

Since the IRS first introduced them for the 2021 tax year, Schedules K-2 and K-3 have caused concerns—and confusion—for many partnerships and S corporations. The purpose of the two schedules is to report information related to foreign financial activities, but some pass-through entities found themselves subject to the forms’ requirements—even though they had no foreign interests or concerns.

Recent revisions to the K-2 and K-3 instructions, released in December 2022 (Partnership Instructions for Schedules K-2 and K-3; Form 1065; 2022 and S Corporation Instructions for Schedules K-2 and K-3; Form 1120-S; 2022), provide some relief, but many entities could still encounter unexpected compliance challenges for the 2022 tax year.

The Underlying Issue—K-2 and K-3 at a Glance

The IRS introduced Schedules K-2 and K-3 as tools for pass-through entities to provide their owners (either partners or S corporation shareholders) with the information they need to complete their personal tax returns, particularly relating to international tax questions and forms, such as foreign tax credits. The draft instructions for 2021 indicated that an entity would not need to complete the forms if it did not have any items “of international tax relevance,” such as international sales or foreign owners.

Complications arose, however, after the agency’s final 2021 instructions required that an entity with no foreign activity of its own would nevertheless be required to file Schedules K-2 and K-3 if any of its individual owners had “relevant foreign activity,” such as a credit for foreign taxes withheld from mutual fund or stock dividends. It did not matter if the owners’ personal foreign investments were unrelated to the pass-through entity’s business—the entity would still be required to file Schedules K-2 and K-3 with the IRS and provide all shareholders or partners with a Schedule K-3 for their personal returns.

This was more than just a minor inconvenience for many businesses. Each schedule was at least a dozen pages long, with instructions numbering an additional 30 pages or more. Some of the required information was not readily available, and often the shareholders or partners were unaware they would need the information until they received year-end tax statements from their brokerages or fund managers.

The IRS did offer some filing relief for 2021 but it was uncertain if this relief would continue for the 2022 tax year.

The Domestic Filing Exception—Evolving Rules

For 2022, the IRS added a new domestic filing exception that relieves some S corporations and partnerships from the K-2 and K-3 filing requirements, provided they meet certain criteria.

To qualify, the entity must have little or no foreign activity (such as $300 or less in foreign income taxes paid or accrued). In addition, all partners or shareholders must be individual U.S. citizens or resident aliens. There are exceptions for certain trusts, estates, single-member S corporations, and other special situations.

To use the domestic filing exception, the entity must provide written notification to its partners or shareholders that they will not receive a Schedule K-3 unless they request one. This requirement generated confusion in recent months. As the IRS made revisions to the K-2 and K-3 draft instructions during 2022, the deadlines for providing this notice changed several times, as did the required notification process itself.

Where Things Stand

In early December 2022, the IRS issued what appears to be the last round of revisions to these instructions for the 2022 tax year. Under the final instructions, entities can provide the required Schedule K-3 notification to partners or shareholders as an attachment to the Schedule K-1, which is due when they file their annual Form 1065 or Form 1120-S tax return. This is a considerable improvement from previous drafts that would have imposed much earlier deadlines.

Individual partners or shareholders who need a Schedule K-3 must request it from the entity at least one month before the entity files its Form 1065 or Form 1120-S so that the entity has time to prepare and file both schedules as part of its return. If the entity does not receive any K-3 requests by this one-month date (and assuming it meets the other domestic exception requirements), it will be exempt from filing the two schedules for the 2022 tax year.

Please note: while the entity will be exempt from filing the schedules, it is not necessarily exempt from preparing them. That’s because partners or shareholders might not realize they will need a Schedule K-3 until after the entity has already filed its return. In such cases, owners can still request a K-3, and the entity will have one month to provide it to them, but it will not be required to file the form with the IRS.

What Entities and Owners Should Be Doing Now

While the domestic filing exception provides some relief from the filing requirements, pass-through entities should nevertheless be prepared to complete Schedules K-2 and K-3 if a partner or shareholder requests it.

For their part, owners should review their year-end investment statements as early as possible to identify events that might trigger the need for a K-3.

The introduction of Schedules K-2 and K-3 created complex filing requirements and informational disclosures, possible filing exceptions, and significant penalties for non-compliance. Please contact us to learn how these new requirements and exceptions may impact your 2022 tax returns.