For taxable years beginning in 2021, flow-through entities were required to include two new schedules K-2 and K-3 when filing their income tax returns. Schedules K-2 and K-3 replace certain portions of Schedule K and standardize the reporting of items of international tax relevance and partners’/shareholders’ distributive shares of items of international tax relevance.
In response to tremendous feedback and requests for relief from the tax community, the IRS issued Notice IR-2022-38 in February 2022, offering transition relief to certain domestic partnerships and S corporations by allowing them an exception to filing Schedules K-2 and K-3 for tax year 2021 if certain conditions were met. But this transition relief was only applicable to tax year 2021, leaving uncertainty around relief related to 2022 and future tax years.
In October and November 2022, the IRS originally issued draft instructions for 2022 partnership and S corp schedules K-2 and K-3, which included a “Domestic Filing Exception” that exempts entities from filing these schedules if certain criteria and notification requirements are met. More recently, in December 2022, the IRS revised these draft instructions and changed the notification requirements and other criteria.
Under the revised instructions a domestic partnership/S corp does not need to: (1) complete and file Schedules K-2 and K-3 with the IRS, or (2) furnish Schedule K-3 to a partner/shareholder (except where requested by a partner/shareholder after the 1-month date, as defined in criterion #4 below) if each of the following criteria are met with respect to the partnership/S corp’s tax year 2022:
1. No or Limited Foreign Activity
During the tax year the partnership/S corp either has no foreign activity or its foreign activity is limited to:
- Passive category foreign Income (determined without regard to the high-taxed income exception)
- $ 300 or less of Foreign Tax Credits allowable under Sec 901 treated as paid or accrued by the partnership/S corp
Such income and foreign taxes must be shown on a payee statement furnished or treated as furnished to the partnership/S corp.
For the purpose of the Domestic Filing Exception, foreign activity means:
- Foreign income taxes paid or accrued
- Foreign source income or loss
- Ownership interest in a foreign partnership or foreign corporation
- Ownership of a foreign branch
- Ownership interest in a foreign entity that is treated as a disregarded entity
2. U.S. Citizen/Resident Alien Partners (This criterion is omitted for S corps)
All direct partners of the domestic partnership are:
- U.S. citizen individuals,
- Resident alien individuals,
- Domestic decedent’s estate with solely U.S. citizen and/or resident alien individual beneficiaries,
- Domestic grantor trusts with solely U.S. citizen and/or resident alien individual grantors and beneficiaries,
- Domestic non-grantor trusts with solely U.S. citizen and/or resident alien individual beneficiaries,
- S corp with a sole shareholder, or
- Single-member LLCs, where the LLC’s sole member is one of the persons in (a) through (f) above, and the LLC is disregarded as an entity separate from its owner.
Thus, multi-tiered partnerships are excluded from the domestic filing exception.
3. Partner/Shareholder Notifications
The partnership/S corp must notify its partners/shareholders either electronically or by mail no later than when the partnership/S corp furnishes Schedule K-1 to the partner/shareholder. The notice can be provided as an attachment to Schedule K-1. The notification must state that partners/shareholders will not receive Schedule K-3 from the partnership/S corp unless the partners/shareholders request the schedule.
4. No 2022 Schedule K-3 requests by the one-month date
If the partnership/S corp receives a request from one of its partners/shareholders for Schedule K-3 after the one-month date and has not received a request from any other partner/shareholder on or before the one-month date, then the Domestic Filing Exception is met, and the partnership/S corp is not required to file Schedules K-2 and K-3 with the IRS or provide Schedule K-3 to any non-requesting partner/shareholder.
The “one-month date” is one month before the date the partnership/S corp files its tax return.
For calendar year 2022 partnerships/S corps, the latest 1-month date is August 15, 2023, if the partnership/S corp files an extension.
The partnership/S corp must provide the schedule K-3 to the requesting partner/shareholder on the latter of the date that the partnership/S corp files its tax return or one month from the date on which it receives the request from the partner/shareholder.
Note: For partnerships that satisfy criteria 1 through 3 and S corps that satisfy criteria 1 and 3 for S corp, but do not satisfy criterion 4, the following applies:
If the partnership/S corp receives a request from a partner/shareholder for the schedule K-3 on or before the one-month date, then the Domestic Filing Exception is not met, and the partnership/S corp is required to file Schedules K-2 and K-3 with the IRS and provide them to the requesting partner/shareholder. Schedules K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting partner/shareholder. The partnership/S corp does not need to complete, attach, file, or furnish any other parts or sections of Schedules K-2 and K-3 to the IRS, the requesting partner/shareholder, or any other partner/shareholder. The partnership/S corp should keep records of the information requested by the partner/shareholder.
If you have any questions on your organization’s eligibility for this filing relief, please contact your Grassi advisor or Shashi Singal, Tax Partner, for more information.