K-2 and K-3 domestic filing exceptions welcome, but narrow

| 11/17/2022
K-2 and K-3 domestic filing exceptions welcome, but narrow

On Oct. 25, the IRS released draft instructions for the 2022 Form 1065, “U.S. Return of Partnership Income”: Schedule K-2, “Partners’ Distributive Share Items – International,” and Schedule K-3, “Partner’s Share of Income, Deductions, Credits, etc. – International.” These forms provide the IRS and partners with standardized information about partnership items of international tax relevance. The draft instructions provide a new domestic filing exception. If a domestic partnership meets each of the qualifications for the exception, it will be exempted from filing the schedules for the 2022 tax year. The domestic filing exception has four basic requirements.

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  1. The partnership must have no or limited foreign activity. Foreign activity is defined as foreign income taxes paid or accrued, foreign-sourced income or loss, and ownership in a foreign partnership, foreign corporation, foreign disregarded entity, or foreign branch. The presence of any of these foreign activities or ownerships will require filing Schedule K-2 and Schedule K-3. Limited foreign activity is permitted provided the activity is passive, there is less than $300 of related foreign taxes allowable as credit, and the income and taxes are provided on a payee statement provided to the partnership.
  2. During the year, the partnership only can have partners that are U.S. citizens, resident aliens, estates with domestic decedents, domestic trusts with only U.S. citizens, or resident alien grantors and beneficiaries.
  3. The partnership must send a notification to all the partners at least two months before the Form 1065 due date (without extension) notifying them that they will not be receiving a Schedule K-3 unless one is requested.
  4. The partnership cannot have received a request for a Schedule K-3 on or before the date that is one month before the unextended due date of the Form 1065 (one-month date). If the partnership receives a request from a partner for a Schedule K-3 after the one-month date has passed but has not received any requests for the Schedule K-3 before the one-month date, the partnership will have met this fourth requirement, but it still will be required to provide the requesting partner a Schedule K-3.

Looking ahead

The Schedule K-2s and K-3s are very burdensome, and for partnerships that do not have involvement with non-U.S. businesses, investments, and investors, this extra reporting could seem unnecessary. As such, the draft instructions allowing for an exception from completing the Schedule K-2 and Schedule K-3 for domestic partnerships is a welcome development. However, partnerships should carefully analyze whether they meet the domestic partnership exception because the requirements are very narrow.

Comments on the draft instructions were due on or before Nov. 8, 2022. Because that comment period didn’t leave much time for stakeholders to provide feedback to the IRS before it finalizes the instructions for 2022, it is possible that the exception will remain unchanged for 2022.

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John Kelleher
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