2022 Schedule K-2/K-3 Update
By Julie Dale, CPA-Austin, and Josh Whitworth, CPA-Dallas, CVA
Schedules K-2/K-3 were introduced in 2021 to help provide partners in partnerships and shareholders in S corporations the information needed to properly report foreign income, deductions and tax credits. This article will use the words “entity” and “owner” so that both S corporations and partnerships are included.
In 2021, these schedules were not required if (a) the entity is organized in the U.S., (b) there are no direct foreign owners, (c) the entity had no foreign activity, (d) no supplementary information was provided in 2020 to partners regarding foreign reporting, and (e) the entity does not anticipate owners to request supplementary foreign information for 2021.
For 2022, the domestic filing exception has narrowed and requires the following four criteria be met:
- No or limited foreign activity. To meet the limited foreign activity definition, the entity must have only passive foreign income with associated foreign taxes not to exceed $300 and must provide a payee statement as defined in Section 6724(d)(2).
- U.S. citizen/resident alien owners. All direct owners are:
- U.S. citizen individuals,
- Individuals who are resident aliens,
- Domestic decedent’s estates,
- Domestic grantor trusts with only grantors and beneficiaries who are U.S. citizens/resident aliens,
- Domestic non-grantor trusts with only beneficiaries who are U.S. citizens/resident aliens,
- S corporations with a single shareholder; or
- Single-member LLCs that are disregarded entities with a single owner meeting a definition in (a) through (f) above.
- Owner notification. The owners must be notified that the entity does not intend to provide Schedule K-3 unless requested. This notification can be provided with Schedule K-1 but doing so can be troublesome as illustrated below.
- No 2022 Schedule K-3 requests by the one-month date. The entity does not receive a request for Schedule K-3 within one month before the entity files its return.
Please note that the domestic filing exception will not apply to tiered partnerships. The notification requirement changes the filing procedures for partnerships and S corporations in 2022 if the domestic filing exception applies. Below are some potential steps to consider when preparing returns excluding the Schedule K-2/K-3 under the domestic filing exception if you choose to provide partner notification with the Schedule K-1:
- Extend the return on March 15.
- Submit the draft return for approval to the partnership representative or the S corporation manager.
- Issue Schedules K-1 to owners once the return is approved with the notice that the return will be filed by a specific date and ask the owners to request the Schedule K-3 by the date one month prior to the anticipated filing date.
- Wait until the target filing date for owners to request Schedule K-3:
- If no Schedule K-3 requests are made, then there is no need to prepare the form.
- If Schedule K-3 is requested prior to the one-month date prior to filing, then the Schedules K-2/K-3 must be prepared and submitted with the return to the IRS, as well as distributing the Schedule K-3 to the requesting owner. The sections of Schedules K-2/K-3 that must be completed will depend upon what the owner requests. The entity must provide the requested Schedule K-3 on the later of the date the tax return is filed or one month after the request is received.
- If Schedule K-3 is requested after the one-month date, then the Schedule K-3 must be provided to the requesting owner but is not required to be submitted to the IRS. The entity must provide the requested Schedule K-3 on the later of the date the tax return is filed or one month after the request is received.
This is an extremely cumbersome process and nothing like what we have done in the past. This requires issuing the Schedules K-1 prior to filing the return, which is contrary to normal practice. It may be best to be proactive and have the partnership representative or S corporation manager notify the owners during or prior to the preparation process that the Schedule K-3 will not be included unless requested. If you are able to provide a target filing date, then you can give owners the deadline for them to respond with whether the Schedule K-3 is needed. It may be wise to consider filing extensions to leave a possibility of submitting a superseding return if needed. This would be especially important for partnerships subject to the centralized partnership audit regime under the BBA.
Although the Schedules K-2/K-3 are for reporting international activities, some sections of the form may still be required even when there is only domestic activity in the entity. Parts II and III will apply to most entities since these also include inputs for U.S. income, deductions and assets, as well as inputs for foreign activities. If the underlying ownership of any partnership owners is unknown, then the following schedules may need to be completed even with only domestic activity since there could be an underlying C corporation owner: Parts IV (FDII), IX (BEAT) and X (ECI/FDAP). The 2022 Schedule K-2/K-3 instructions have a better summary of what type of activity is reported on each part in the section entitled “How to Complete Schedules K-2 and K-3.” Since foreign activity reporting is so complex, it may still be necessary to dive into code sections and regulations to understand the concepts and the acronyms.
The IRS still has time to change its mind on the mechanics of the domestic filing exception since it did so for 2021 in February 2022. Fortunately, that change in February 2022 made it easier for returns to be filed and we would hope that the same would be true for any 2022 change the IRS may consider this late in the game. There may be further developments on this as tax season progresses and you may need to refer to resources outside of the form instructions to find details on any relief the IRS may provide.
IRS Schedules K-2 and K-3 FAQs (Forms 1065, 1120S, and 8865)
What’s the 411? Explaining Schedules K-2 and K-3 | AICPA Journal of Accountancy