Narrow Exceptions to K-2 and K-3 Filing Requirements are in place – Will Your Pass-through Entity Benefit?

Partnerships got their first taste of the expanded Schedule K-2 and Schedule K-3 reporting requirements last year when they went into effect for the 2021 tax year, and for many, they  went down like a bitter pill. The big changes involved two new schedules that stretched to approximately 20 pages each, requiring vastly more detailed reporting on foreign income and investments than previous requirements.

But the limited forbearance on compliance that the IRS showed last year is gone this year, and while the IRS’s new revised domestic filing exception is important, it is much narrower than what many had hoped for.

The exception was not extended to partnerships with direct partners who are domestic corporations or domestic partnerships. Therefore, it is highly likely that the filing exception will apply to very few domestic partnerships.

Partnerships that want to take advantage of this exception need to analyze each criterion and obtain and retain the proper documentation to take advantage of it. Specifically, in connection with the 1-month date, partnerships will need to closely monitor requests from their partners for the Schedule K-3 and their timing compared to the expected filing date. Even if a request arrives after the 1-month date and the partnership otherwise meets the other three criteria, the partnership would still be required to provide a Schedule K-3 to the requesting partner.

Background

The IRS released new schedules for international tax reporting using pass-through entities, effective with the 2021 tax year. The standardized format of the schedules helps pass-through entities in providing partners and shareholders with information required on their tax returns with respect to international provisions of the Internal Revenue Code and allows the IRS to verify tax compliance more easily.

The forms required for partnerships with foreign activities are:

• Schedule K-2, Partners’ Distributive Share Items – International; and
• Schedule K-3, Partner’s Share of Income, Deductions, Credits, etc. – International

When are Schedule K-2 and Schedule K-3 required?

Starting with taxable years beginning in 2021, schedules K-2 and K-3 are new schedules to accompany tax Forms 1065, 1120-S, and 8865 required of pass-through entities. Schedule K-2 is an extension of Schedule K and offers a standardized format to report items of international tax relevance from the operation of the pass-through entity.

According to the IRS, Schedules K-2 and K-3 were created to provide consistency in the reports for partners and shareholders. Prior versions of schedules K and K-1 did not require any specific format to provide international information, resulting in a confusing mix of statements attached to the schedules K and K-1. The new Schedules K-2 and K-3 provide greater certainty and consistency.

However, the new schedules also require more reporting, and in some cases, even partnerships with no foreign income are required to file the K-2 and K-3 if a single member has international investments that are unrelated to the partnership. This has raised intense opposition from tax practitioners and businesses.

There are limited exceptions to the K-2 and K-3 filing requirements as outlined below.

Partnership Exception

A domestic partnership is exempt from filing Schedules K-2 and K-3 or furnishing a Schedule K-3 to a partner (except if requested by a partner after the one-month date) if each of the following four criteria is met:

1. There is no foreign activity or there is no limited foreign activity.  During a domestic partnership’s tax year, the domestic partnership either has no foreign activity or, if it does, such foreign activity is limited to (a) passive category foreign income; (b) upon which not more than $300 of foreign income taxes allowable as a credit are treated as paid or accrued by the partnership; and (c) such income and taxes are shown on a payee statement that is furnished or treated as furnished to the partnership;
2. U.S. citizen/resident alien partners. During the tax year, all the direct partners in the domestic partnership are: (a) individuals that are U.S. citizens; (b) individuals that are resident aliens; (c) domestic decedent’s estates (that is, decedent’s estates that are not foreign estates), with solely U.S. citizen and/or resident alien individual beneficiaries; (d) domestic grantor trusts that are not foreign trusts and that have solely U.S. citizen and/or resident alien individual grantors and solely U.S. citizen and/or resident alien individual beneficiaries; or (e) domestic non-grantor trusts and solely U.S. citizen and/or resident alien individual beneficiaries;
3. Partner notification. With respect to a partnership that satisfies criteria 1 and 2, the partners must receive a notification from the partnership when the partnership furnishes the Schedule K-1 to the partner at the latest. The notice can be provided as an attachment to the Schedule K-1. The notification must state that partners will not receive the Schedule K-3 from the partnership unless they request it.
4. No 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 one-month date. The “1-month date” is one month before the due date the partnership filed Form 1065. For tax year 2022 calendar-year partnerships, the latest 1-month date is August 15, 2023, if the partnership files an extension.

If a partnership receives a request for the Schedule K-3 information after the 1-month date and has not received a request from any other partner for the Schedule K-3 information on or before the 1-month date, the domestic filing exception is met, and the partnership is not required to file the Schedules K-2 and K-3 with the IRS or furnish the Schedule K-3 to the non-requesting partners. However, the partnership is required to provide the completed Schedule K-3, along with the requested information, to the requesting partner 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 partnership received a request from a partner for Schedule K-3 information on or before the 1-month date and therefore does not satisfy criterion 4, it is required to file Schedules K-2 and K-3 with the IRS and furnish the Schedule K-3 to the requesting partner. The Schedules K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting partner.

S-Corporation Exception

An S-corporation does not need to complete and file Schedules K-2 and K-3 or furnish a Schedule K-3 to a shareholder (except if requested by a shareholder after the 1-month date) if each of the following three criteria is met:

1. No foreign activity or limited foreign activity. During a domestic S-corporation’s tax year, the S-corporation either has no foreign activity or, if it does, then it is limited to (a) passive category foreign income; (b) upon which not more than $300 of foreign income taxes allowable as a credit under IRC 901 are treated as paid or accrued by the S-corporation, and (c) such income and taxes are shown on a payee statement that is furnished or treated as furnished to the S-corporation;
2. Shareholder notification. With respect to an S-corporation that satisfies criterion 1, the shareholders must receive a notification from the S-corporation either electronically or by mail, dated no later than two months before the due date (without extension) for filing the S-corporation’s tax year Form 1120-S (January 15, 2023).
   S-corporations that meet the criteria need to provide notification to the shareholders of the entity when the S-corporation furnishes the Schedule K-1 to the shareholder at the latest. The notification needs to state that shareholders will not receive the Schedule K-3 from the entity unless the shareholder requests it.

3. No Schedule K-3 requests by the 1-month date. If an S-corporation receives a request for the Schedule K-3 information after the 1-month date and has not received a request from any other shareholder for Schedule K-3 information on or before the 1-month date, the domestic filing exception is met , and the S-corporation is not required to file the Schedules K-2 and K-3 with the IRS or furnish the Schedule K-3 to the non-requesting shareholders. The “1-month date” is one month before the due date of the S-corporation’s Form 1120-S. For example, for a calendar tax year 2022 S-corporation that files an extension, the latest 1-month date is August 15, 2023. However, the S-corporation is required to provide the Schedule K-3, complete with the requested information, to the requesting shareholder on the later of: (1) the date on which the S-corporation files Form 1120-S, or (2) one month from the date on which the S-corporation receives the request from the shareholder. If an S-corporation meets criteria 1 and 2, but not 3, and receives a request from a shareholder for Schedule K-3 information on or before the 1-month date, the S-corporation is required to file Schedules K-2 and K-3 with the IRS and furnish Schedule K-3 to the requesting shareholder.

How Anchin Can Help

This is a brief overview of the narrow exceptions to the new Schedule K-2 and Schedule K-3 filing requirements. For further information on how these filing requirements will affect your pass-through entity, please reach out to George Teixeira or your Anchin Relationship Partner.

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