Revised Schedules K-2/K-3 Instructions Related to “Domestic Filing Exception”

Effective with tax year 2021, if a partnership/S corporation has items of international relevance (e.g., foreign source income, foreign tax credits, foreign partners, investments in foreign entities), it must prepare and file not only Schedules K and K-1 (“Old Schedules”) but also Schedules K-2 and K-3 (“New Schedules”).

The purpose of the New Schedules is to:

• Enable pass-thru entities (and those required to file Form 8865) to provide a standard format of information of international relevance to the partners/shareholders.
• Let partners/shareholders to easily translate this information on their own return.
• Allow the IRS to verify taxpayer compliance more efficiently.

Originally, the IRS intended all partnerships to comply with the requirement to issue New Schedules.  However, in response to concerns from several practitioners, in October 2022, the IRS created a “domestic filing exception.” Partnerships without any foreign activity or foreign partners were exempt from filing New Schedules if the partners/shareholders were notified by January 23, 2023, that they would not receive Schedule K-3 information and partners/shareholders requested the New Schedules.

In response to concerns regarding this January 23, 2023, notification requirement, the IRS issued revised Form 1065 and Form 1120S instructions on December 2, 2022 (Form 1065), and December 5, 2022 (Form 1120S). Under these revised instructions, an eligible partnership/S corporation that wants to avail itself of the domestic filing exception can:

• Inform partners/shareholders that no Schedule K-3 will be provided as late as Schedule K-1 is sent to the partners/shareholders, and this information can be an attachment to the K-1.
• If the partner/shareholder wants Schedule K-3, it is the duty of the partner/shareholder to request it from the partnership/S corporation. This request should be made by the partner/shareholder one month before the due date for filing the partnership/S corporation return.

Thus, under new instructions for tax year 2022, the eligible partnership/S corporation can inform partners/shareholders that no K-3 will be issued as late as March 15, 2023, or in case of an extension as late as September 15, 2023. On the other hand, a partner/shareholder who wants Schedule K-3 may inform the eligible partnership/S corporation on or before February 15 and if an extension is filed by the partnership/S corporation on or before August 15, 2023.  

What is a domestic filing exception, and what are the circumstances under which a partner/shareholder may not receive Schedule K-3 from a partnership/S corporation?

1. The domestic filing exception can only be used by S corporations or domestic partnerships.
2. A foreign partnership cannot use the domestic filing exception, must send Schedule K-3 to all its partners, and file New Schedules K-2/K-3 with the IRS with respect to all its partners and shareholders.
3. The domestic partnership or S corporation must meet the following parameters to take advantage of the domestic filing exception and need not provide Schedule K-3 to partners/shareholders, unless specifically requested by a partner/shareholder:
   1. The domestic partnership/S corporation has no foreign activity, or foreign activity is limited as discussed in (a)(ii) below.
      1. Foreign activity means that the domestic partnership/S corporation’s activity has any of the following elements:
         • Paid or accrued foreign income taxes (see limited foreign activity exception here).
         • Has foreign source income or loss.
         • Has ownership interest in a foreign partnership.
         • Has ownership interest in a foreign corporation.
         • Has ownership of a foreign branch.
         • Has an interest in a foreign disregarded entity.
      2. Limited foreign activity means the foreign activity of the domestic partnership/S corporation is limited to:
         • Producing passive category foreign income irrespective of high tax kickout.
         • Allowable foreign tax paid or accrued is not more than $300.
         • Such income and taxes are shown on payee statement available to the domestic partnership/S corporation.
   2. All direct partners in the domestic partnership are:
      1. Individuals who are U.S. citizens or resident aliens.
      2. Domestic decedent’s estates with solely individual beneficiaries who are U.S. citizens and/or residents.
      3. Domestic grantor trusts with solely individual U.S. citizen and/or resident alien grantor or beneficiaries.
      4. Domestic non-grantor trusts with solely individual U.S. citizen and/or resident alien grantor or beneficiaries.
      5. S corporations with a sole shareholder.
      6. Single member LLCs where the LLC member is solely an individual U.S. citizen and/or resident alien.

Note that the Form 1120S instructions do not specify similar conditions under Form 1065 instructions as to who the shareholders should be because the basic rules applicable to S corporations are only U.S. citizens and permanent residents are allowed S corporation shareholders. That is true of the owners/beneficiaries of grantor trusts, estates of deceased shareholders (subject to limited exception) and other eligible shareholders of an S corporation.

Note that the Form 1120S instructions do not specify similar conditions under Form 1065 instructions as to who the shareholders should be because the basic rules applicable to S corporations are only U.S. citizens and permanent residents are allowed S corporation shareholders. That is true of the owners/beneficiaries of grantor trusts, estates of deceased shareholders (subject to limited exception) and other eligible shareholders of an S corporation.

What should a domestic partnership/S corporation do if it meets the domestic filing exception and does not wish to/need not issue Schedule K-3?

The domestic partnership/S corporation should categorically inform partners/shareholders that they will not receive Schedule K-3 unless the partner/shareholder specifically requests Schedule K-3. This notification can be issued as late as the date when Schedule K-1 is issued to the partners/shareholders.    

What should a partner/shareholder do to receive Schedule K-3 from a domestic partnership/S corporation? What should a domestic partnership/S corporation do if it receives a Schedule K-3 request from partner/shareholder?

The partners/shareholders need not wait to receive a notification from the domestic partnership/S corporation that a K-3 will not be issued. If the partner/shareholder believes that for tax year 2022 a partnership/S corporation may not issue Schedule K-3, it may simply request that Schedule K-3 be issued.

While this request should be made on or before one month from the actual filing of the partnership/S corporation return, nothing prevents a partner/shareholder from making this request earlier or later than this date. However, the date of receipt of Schedule K-3 by the requesting partner depends on when this request is made (see table below):

When and why may a partner/shareholder request a Schedule K-3 from the partnership/S corporation that otherwise meets the domestic filing exception, or when may such domestic partnership/S corporation issue the Schedule K-3 to its partners?

Here are some examples:

• A high-net-worth individual has investments in multiple partnerships/S corporations:
  1. Some investments have extensive foreign activities.
  2. Some investments have limited foreign activities.
  3. Some investments generate large passive foreign source income but no foreign tax credits, for example, because income is generated in a foreign jurisdiction with no tax.
  4. Some investments generate foreign source income and substantial foreign tax credits.
  5. Some investments generate foreign general category or foreign branch category income.
  6. Some investments are foreign partnerships.
  7. Some investments generate foreign source income with less than $300 foreign tax credit.
  8. Some investments have no foreign activity at all.

This individual will most likely receive Schedule K-3 from their investments in “a” to “e” but not from “f” to “h.” He/she may consider seeking Schedule K-3 from an investment described in “g” if it seems that the combined foreign tax credit from these investments can be substantial either given the number of these investments or the total foreign tax credit from these investments can be substantial. 

• A non-grantor trust with a foreign beneficiary is a direct partner in the partnership. Either the partnership needs to know who the beneficiaries are in the non-grantor trust or, to be compliant, issue Schedule K-3 to the non-grantor trust partner.
• A domestic partnership/S corporation’s passive investing activity may vary year after year and may generate more or less than $300 foreign tax credit. The partner/S corporation may consider seeking Schedule K-3 from this partnership each year and this partnership/S corporation may consider issuing Schedule K-3 each year.

Unless a partnership/S corporation is truly a domestic partnership with consistently de minimis passive foreign source income and foreign tax credits, and no foreign activity, it may be prudent to issue Schedules K-2 and K-3. This will help avoid last minute scrambling if partners/shareholders request Schedule K-3 and avoid having partner/shareholders guessing whether Schedule K-3 should be requested or not.