Take Two: 2022 Updated K-2 and K-3 Domestic Filing Exception
November 16, 2022
By Matthew Talia
On October 25, 2022, the IRS released draft 2022 Schedules K-2 and K-3 instructions. After a chaotic 2021 tax season that left many tax practitioners and investment managers of domestic pass-through entities with substantially all domestic activity in limbo, some clarity has been provided as to who has a responsibility to file Schedule K-2s and distribute K-3s to their partners. Entities that derive large foreign source income, have foreign partners, assets generating foreign source income, or significant foreign taxes paid or accrued should expect to file K-2 and K-3. However, the new instructions will result in analysis on an entity-by-entity basis to determine if the schedules are necessary for a large swath of domestic entities with little foreign activity. Previously, to qualify for a domestic filing exception, a partnership had to have direct partners that were U.S.-based, no current year foreign activity, no prior year foreign information provided on Schedule K-1 (Line 16), and no knowledge that the partners or shareholders were requesting K-3 information.
New in 2022 for a domestic partnership, there are four criteria that must all be met to be granted a domestic filing exception for Schedules K-2 and K-3. Below is a brief overview of each criterion and some takeaways. Please note there are some nuances to each detailed in the IRS draft instructions and this a high-level overview:
1. No or Limited Foreign Activity: If an entity has no foreign activity, or an entity only has foreign passive activity upon which $300 or less of foreign income taxes were paid or accrued.
Analysis: It is important to note that prior year activity is not relevant in this analysis as it was during the 2021 tax year; only the current year activity must be analyzed. For the vast majority of larger clients, or clients with a substantial foreign portfolio, it is unlikely this exemption will be met. The threshold is notably low, particularly for funds with significant capital under management. Additionally, the income must be of the passive variety. For example, if a fund is invested in a pass-through entity that has non-passive activity, they would fail this test. Fund of fund entities should contact their investment managers to ascertain whether they engaged in foreign activity, and what type.
2. U.S. Citizen/Resident Alien Partners: If all the direct partners in the domestic partners are either U.S citizens, resident aliens, domestic decedents’ estates, domestic grantor trusts, or domestic non-grantor trusts.
Analysis: While most partner types are included on the above list, it is particularly notable that pass-through entities as well as corporations are excluded. Large funds typically contain partners that are corporations and/or pass-through entities. Since partnership structures are often tiered and may have varying visibility through each tier, it is likely that an indirect partner of a partnership or a corporation will require a Schedule K-3 to properly satisfy their own filing obligation. GP entities and management companies are often structured in a manner that is compliant with this criterion, so assuming the other criteria are met, they can potentially benefit from this exemption. It is very important to know your investor base and their tax classification.
3. Partner Notification: If criteria one and two are met, partners are to receive a notification from the partnership electronically or by mail dated no later than two months before the due date (without extension) for filing the partnership’s tax year 2022 Form 1065. The notification must state that partners will not receive Schedule K-3 from the partnership unless the partners request the schedule.
Analysis: This may be the most important criterion, as it changes the process tax practitioners and entities must undergo to be in full compliance with the IRS. January 15 becomes a monumentally important date, as it is two months before partnership (Form 1065) returns are due without extension. Tax practitioners and clients must work together to determine if all the other criteria are met, and to ensure that each partner receives proper and timely notification. This notification process should be documented so there are no misunderstandings resulting in non-compliance.
4. No 2022 Schedule K-3 Requests by the 1-month date: The partnership does not receive a request from any partner for Schedule K-3 information on or before the 1-month date, which is defined as one month before the due date (without extension) of the partnership’s Form 1065. If a request is received from a partner on or before the 1-month date, the partnership must file Schedules K-2 and K-3 and attach them to the tax return. The forms must be completed only with respect to the parts and sections relevant and requested by the partner. The partnership does not need to complete sections that are not relevant or requested by the partner. For requests received after the 1-month date, the partnership is required to provide Schedule K-3, completed with the partner’s requested information on the later of the date on which the partnership files the Form 1065, or one month from the date on which the partnership receives the request from the partner. If the request is made after the 1-month date, the partnership need not file Schedules K-2 and K-3 with the IRS but provide Schedule K-3 to the requesting partner directly.
In instances where a partnership receives requests from partners both before and after the 1-month date, the partnership must file K-2 and K-3 with the relevant requested sections for the partner(s) whom requested before the 1-month date with the tax return, and for those who requested after the 1-month date, a K-3 must be furnished (but not attached to the tax return) on the later of the date on which the partnership files Form 1065, or one month from the date on which the partnership receives the request from the partner.
Analysis: As a result of this criterion, February 15 also becomes a very important date. Clients must endeavor to make sure that communications made by investors do not fall through the cracks and inform their tax preparer if they received any responses to the notification. It is essential to set up a documentable formal process for a partner to communicate to an investment manager if they wish to receive a Schedule K-3, and what parts of the form they require. This is a large improvement over the prior process, where there was great uncertainty as to whether a partner would request the forms and potentially cause a scramble to provide them in a timely manner. In essence, investors now have a due date that provides tax practitioners and clients with more clarity earlier in the year regarding the scope of their engagement. However, it is very likely requests will be received after the 1-month date, so there is still uncertainty inherent in the process. Since most entities are on extension and filed well after March 15, there should be adequate time to provide late requestors with the information needed. The scope of the work and information provided should be narrower in nature since only the relevant and requested parts of the form need be completed.
The 2022 K-2 and K-3 draft instructions represent a move in the right direction; there is more clarity for investment managers, investors, and tax practitioners alike. Unsurprisingly, the new instructions will result in some complications and process changes. If the domestic exemption may be applicable to your entity, it is extremely important to start taking steps to institute a formal process to communicate with partners. It would be advisable for tax advisors and clients to touch base before or right after year-end on activity that occurred during the year, the structure of the entity, investor composition, and the nature of the communication between the entity and its investors. For entities that may qualify for the domestic exemption with less voluminous and onerous K-2/K-3 forms, it might make sense to fill out the form proactively and distribute K-3s to investors rather than take the chance it is requested using the new 1-month date mechanism. The extra layer of notifications and communications between partnerships and their investors could possibly be more time consuming and burdensome than filling out the forms themselves. This is something to strongly consider when discussing the approach to 2022 K-2 and K-3 reporting. It is clear the IRS is aware of daunting challenges encountered during the 2021 tax season and is taking small steps to remedy them.