In December 2022, the IRS finalized partnership instructions for filing and furnishing Schedules K-2 and K-3 for tax years beginning in 2022, including the addition of a new exception for domestic U.S. partnerships. This article summarizes what you need to know.
What is the purpose of schedules K-2 and K-3?
Schedules K-2 and K-3 were designed to increase transparency and clarity on reporting relative to a partnership’s international activities to better enable partners to report foreign income, deductions, credits, or other relevant items on their tax returns.
In tax years prior to 2021, investment partnerships with international activities often provided relevant international tax information through disclosures created in various forms, including footnotes, supplemental schedules, and pro-forma documents attached to Schedule K-1. With the release of Schedules K-2 and K-3, partnerships use these schedules to provide relevant international tax information in a standard format.
The new schedules require more detailed reporting than partnerships have been providing previously to partners that was necessary for them to accurately complete their own returns.
Who needs to file the forms?
In general, partnerships with international activities or foreign partners should carefully review the form instructions to determine the filing requirements with Schedules K-2 and K-3.
Schedule K-2 filers
Schedule K-2 is an extension of Schedule K of Form 1065 and includes the below-listed 11 parts to report items of international tax relevance for the partnership.
Part I, Partnership’s Other Current Year International Information
Part II, Foreign Tax Credit Limitation
Part III, Other Information for Preparation of Form 1116 or 1118
Part IV, Information on Partners’ Section 250 Deduction With Respect to Foreign-Derived Intangible Income (FDII)
Part V, Distributions From Foreign Corporations to Partnership
Part VI, Information on Partners’ Section 951(a)(1) and Section 951A Inclusions
Part VII, Information To Complete Form 8621
Part VIII, Partnership’s Interest in Foreign Corporation Income (Section 960)
Part IX, Partners’ Information for Base Erosion and Anti-Abuse Tax (Section 59A)
Part X, Foreign Partners’ Character and Source of Income and Deductions
Part XI, Section 871(m) Covered Partnerships
Schedule K-3 filers
Schedule K-3 reports partners’ allocable shares of items reported on Schedule K-2. The form also includes one part in addition to the parts in Schedule K-2 (Part XIII, foreign partner’s share of deemed sale items on transfer of partnership interest).
IRS Update: Domestic Filing Exception
For partnerships with activity exclusively within the United States, the biggest update to their filing requirements is a Domestic Filing Exception that exempts partnerships with solely domestic activity and U.S. partners from filing a Schedule K-2 or K-3.
Based on the schedule’s purpose in promoting consistency in reporting items of international tax relevancy by standardizing forms and instructions, the IRS recognized that partnerships with solely domestic activity and U.S. partners generally don’t need to prepare these schedules.
To qualify for this exemption, a partnership must meet each of the following criteria:
- It must have no (or limited foreign) activity during a domestic partnership’s tax year 2022. For purposes 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, corporation, branch, or ownership interest in a foreign entity that is disregarded as an entity separate from its owner.
- During the tax year 2022, the partnership’s direct partners must be individuals that are U.S. citizens or resident alien partners, domestic decedent’s estates or trusts with solely U.S. citizen and/or resident alien individual beneficiaries, S corporations with a sole shareholder, or single-member LLCs where the LLC’s sole member is one of the persons listed above.
- It must provide partner notification. With respect to a partnership that satisfies the first two criteria, partners must receive a notification that they will not receive Schedule K-3 unless upon request from a partner.
- The partnership must not have received a request from any partner for Schedule K-3 information on or before the one-month date before the partnership files the 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 partner wants to receive a Schedule K-3, they must request it from the partnership. If a partnership receives such request on or before the one-month date, the partnership does not satisfy the fourth criterion and is therefore required to file the Schedules K-2 and K-3 and furnish the Schedule K-3 to the requesting partner. Please note that the partnership is only required to complete, file, and furnish to the requesting partner the Schedules K-2 and K-3 parts relevant to the requesting partner; the partnership does not need to complete any other parts or sections of the Schedules K-2 and K-3.
For additional information or to have any of your questions answered, get in touch with our Venture Capital accounting professionals to receive support with K-2 and K-3 forms.
Where Can I Learn More?
- K2 / K3 2022 Form Instructions:
- K2 / K3 FAQ: https://www.irs.gov/businesses/schedules-k-2-and-k-3-frequently-asked-questions-forms-1065-1120s-and-8865