Updates to IRS Schedules K-2 and K-3: International Tax Relevance for Pass-Through Entities
Tax year 2021 was the first year the IRS required Schedules K-2 and K-3 to be filed with partnership and S corporation returns. Schedule K-2 is an extension of Schedule K of Form 1065, Form 1120-S, and Form 8865, and Schedule K-3 is an extension of Schedule K-1 (for each of the relevant forms).
The purpose of Schedules K-2 and K-3 is to provide items of international relevance to partners and shareholders which may be required to calculate their foreign tax credit and to streamline the disclosure of information needed to comply with a host of other international reporting requirements. Information provided includes details associated with passive foreign investment corporations, CFC reporting issues such as GILTI and subpart F, and corporate tax specific issues such as BEAT (base erosion and anti-abuse tax) and FDII (foreign derived intangible income) deductions. For foreign partners, it provides the detail necessary to complete Form 1040-NR or Form 1120-F.
The information reported on Schedules K-2 and K-3 is provided primarily to assist corporate taxpayers by providing additional information to help navigate complex foreign income and tax credit rules. At the individual level, the amount of information reported on these schedules and the format in which it is reported is confusing, which could lead to incorrect or inaccurate calculations and reporting.
For tax year 2022, Schedules K-2 and K-3 are materially the same as the 2021 schedules with a few notable differences. Additionally, Schedules K-2 and K-3, when required to be filed with the IRS, must be filed as part of the electronic file submitted to the IRS and not attached as a PDF. The largest difference when comparing 2021 to 2022 is the creation of the domestic filing exception. There are additional clarifications and changes that are not being covered in this article.
Domestic Filing Exception (DFE)
The new 2022 filing exception has shifted to being partnership- or S corporation-specific rather than requiring detailed knowledge of their owners’ individual filing requirements. The 2022 Schedule K-2 and K-3 instructions provide a new exception for filing these schedules called the Domestic Filing Exception (DFE). The DFE includes four criteria to qualify, all of which must be met with respect to tax year 2022. If the partnership or S corporation meets the DFE, they do not need to file Schedule K-2 or provide Schedule K-3 to the owners.
- Criteria 1: No or Limited Foreign Activity
Foreign activity includes the following: foreign income taxes paid or accrued; foreign source income or loss; ownership in a foreign partnership, branch, corporation, or disregarded entity. However, limited foreign activity can be achieved if the only foreign income earned is passive category income upon which not more than $300 of foreign income taxes are paid or accrued and the income taxes are shown on a payee statement (such as a Form 1099 or Schedule K-1) that is furnished to the partnership.
- Criteria 2: U.S. Citizen or Resident Alien Partners
With respect to Form 1065, direct partners of the partnership must be U.S. citizens or resident alien individuals, domestic estates with solely U.S. individual beneficiaries, domestic grantor trusts that have solely U.S. individual grantors and beneficiaries, domestic non-grantor trusts with solely U.S. individual beneficiaries, S corporations with a sole shareholder, or a single-member LLC where the LLC’s sole member is one of the people listed above and the LLC is disregarded as an entity separate from its owner. This requirement is automatically satisfied with respect to Form 1120-S given that S corporation shareholder status is already restricted by the “eligible shareholder” requirements applicable to maintaining S corporation status and eligible shareholders fall within the requirements noted in the previous sentence.
- Criteria 3: Partner or Shareholder Notification
If the partnership or S corporation satisfies Criteria 1 and 2 above, the partners and shareholders must receive a notification from the entity that states the entity will not provide Schedule K-3 unless the partner or shareholder requests such information. This notification can be attached as a statement to the Schedule K-1 issued to all partners and shareholders of the entity.
- Criteria 4: No 2022 Schedule K-3 Requests by the One-Month Date
The partnership or S corporation does not receive a request from any partner or shareholder for Schedule K-3 information on or before one month from the date the partnership files the Form 1065 or the S corporation files the Form 1120-S. Note: If an owner requests the K-3 outside of the one-month timeline described above, the partnership or S corporation is required to provide the Schedule K-3 information to the requesting owner only and would not meet the domestic filing exception for 2023. However, for tax year 2022, no information must be provided to the IRS based on this request.
Additional Filing Exceptions
There are two additional exceptions that may apply:
- If a partnership does not qualify for the DFE, Parts II and III of Schedules K-2 and K-3 must be completed unless the partnership does not have a direct or indirect owner that is eligible to claim a foreign tax credit. All S corporation shareholders are eligible to claim a foreign tax credit, thus this exception only applies to partnerships.
- A domestic partnership or S corporation is not required to complete Schedules K-2 and K-3 if all partners or shareholders are eligible to claim a foreign tax credit without filing Form 1116 and the entity receives notification of such eligibility from all its owners by the one-month date noted above in Criteria 4 of the DFE. If the entity receives notification from some, but not all, of its owners, the entity does not need to complete the Schedule K-3 for those excepted owners but must complete the Schedules K-2 and K-3 with respect to the owners that either don’t qualify for the Form 1116 exception or didn’t provide the required notification to the entity. These Schedules K-2 and K-3 must also be filed with the IRS.
Other Significant Updates
For tax year 2022, country code “XX” should be used if the partnership or S corporation cannot determine the country or U.S. possession with respect to which the gross income and gross receipts are sourced because the source is determined by the partner. The most common example of income that is sourced by partner is gain or loss from the sale of personal property. However, code “XX” should not be used if an income tax of at least 10% of the gain derived from the sale of personal property is actually paid to a foreign country with respect to such gain. Gain subject to such 10% foreign income tax can be treated as foreign sourced income rather than income sourced by partner.
Additionally, there was an update to Schedule K-2, Part III, Section 2, related to reporting asset information for the allocation and apportionment of interest expense for foreign tax credit limitation purposes. For individuals, note that mortgage interest expense is generally apportioned on a gross income method and would not require the information in Part III, Section 2 for foreign tax credit purposes. For 2022, this section only needs to be completed if the entity or any of the entity’s owners have interest or stewardship expense. If they don’t have interest or stewardship expense, there is no need to fill out this section.
Finally, the reporting in Part I, Table 1, box 1, has been revised to require reporting of gains rather than both proceeds and basis. Also, instead of reporting the date of sale of the property, if the gain is capital, the partnership or S corporation will now report whether the gain is long-term or short-term. Additionally, the partnership or S corporation may now combine stock sales by country instead of listing each stock sale separately. Note that this combination rule is specific to stock sales and does not apply to sales of other types of property.
For additional information about what has changed from the 2021 to 2022 tax filing season, please make sure to review the instructions to the Schedule K-2 and K-3. Additionally, the IRS does publish Frequently Asked Questions that include relevant and timely information and guidance.
Please reach out to your KSM advisor if you have any questions about Schedule K-2 or K-3 or other international tax matters or complete this form.
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