Good News for Pass-Through Entities: IRS Provides Domestic Filing Exception for Schedules K-2, K3
The new exception allows eligible entities to avoid the headaches generally associated with meeting the K-2 and K-3 reporting requirements.
The IRS recently issued revised instructions regarding 2022 Schedules K-2 and K-3 for partnerships and S corporations. In these instructions, the IRS responded to requests for expanded relief and clarity for pass-through entities by adding a new “domestic filing exception.”
You may recall that, beginning with the 2021 tax year, the IRS created two new reporting schedules – K-2 and K-3 – for the stated purpose of providing greater transparency and clarity to partners and shareholders in calculating their U.S. income tax liability from relevant international items.
For most pass-through entities, furnishing the mandated schedules is a complex process that takes significant time and resources. The new exception allows eligible entities to avoid the headaches generally associated with meeting the K-2 and K-3 reporting requirements.
Are You Eligible? The IRS’s updated guidance and the new domestic filing exception provide welcome relief for many partnerships and S corporations. To take advantage of the exception, pass-through entities must meet four criteria:
- The entity’s foreign activity, if any, must be limited as described in the form instructions.
- If the entity is a partnership, all direct partners must be (a) individuals that are a U.S. citizen or resident alien; (b) domestic trusts or estates with solely U.S. citizen and/or resident alien individual grantors and/or beneficiaries; (c) S corporations with a sole shareholder; or (d) single-member LLCs, where the LLC’s sole member is one of the persons described in (a) through (c).
- Partners and shareholders must be timely notified that partners or shareholders will not receive Schedule K-3 unless requested. The eligible entity must notify the partner or shareholder no later than the time at which it furnishes Schedule K-1 to the partner or shareholder. The notice can be provided as an attachment to Schedule K-1.
- No 2022 Schedule K-3 requests are made by a partner or shareholder to the qualifying entity on or before the “one-month date” (i.e., one month before the date the qualifying entity files its income tax returns). For example, for a 2022 calendar year partnership filing on extension, the latest one-month date would be August 15, 2023. If a partner or shareholder requests a Schedule K-3 from the entity after the one-month period, the entity has to provide only the information to the requesting partner or shareholder and does not have to file the Schedules K-2 and K-3 with the IRS.
What Is Required of You. If you believe you are a qualifying partnership or S corporation (refer to items 1 and 2 above) and you wish to avoid completing Schedules K-2 and K-3, you will need to set up a formal process for communicating and providing appropriate notice to your partners or shareholders in accordance with the timelines as stipulated by the IRS.
Also, it is extremely important that you maintain (a) documentation to support the notifications you make to your partners or shareholders and (b) any responses you receive. This is a critical step to ensure that there is no ambiguity and/or misunderstanding with your partners or shareholders that could result in your entity’s non-compliance being disqualified for the new exception.
If your entity wants to move forward with the required steps for qualification under the domestic filing exception, we strongly encourage you to:
- timely notify, electronically or by mail, your partners or shareholders of your entity’s intention not to provide Schedule K-3 unless specifically requested (refer to item 3 above); and
- track and comply with specific requests from partners or shareholders for a Schedule K-3 (refer to item 4 above).
Sample Notification. Here is an example of an e-mail that you can modify for sending to the entity owners to notify them that they will not be provided a Schedule K-3 unless they specifically request it:
Subject Line: [ENTITY NAME] – Schedule K-3 – Tax Year 2022
Dear Owner:
For tax year 2022, [ENTITY NAME] will not be providing to you a Schedule K-3 (Partner/Shareholder’s Share of Income, Deductions, Credits, etc. – International) with your Schedule K-1 package. The entity qualifies for a domestic filing exception because it has no or limited foreign activity. If you need a Schedule K-3, you must request it from us. If you request a Schedule K-3 from us, we will provide it to you within the required timeframe as stipulated by the Internal Revenue Service.
Sincerely,
[ENTITY NAME]
Closing Comments. As we mentioned above, for the communications to qualify as timely notice, the partner or shareholder notification must be made by the qualifying entity no later than the time in which the K-1 is furnished to a partner or shareholder.
Note that if a partner or shareholder makes an untimely request for Schedule K-3 information after the specified one-month period, you have an obligation to provide the Schedule K-3 to the requesting partner or shareholder, but you do not have to file the K-2 and K-3 with the IRS.
Contact Us. As always, please feel free to contact your Walker & Armstrong tax professional with any questions about the new domestic filing exception.
We are available at your request to assist you with addressing the implications of the Schedules K 2 and K 3 reporting requirements to your entity.
