Tax Alert: IRS Widens Exemption for 2022 International Filings with New Schedule K-2 and K-3 Instructions

On December 2, 2022, the IRS issued new draft instructions for both Schedule K-2 and K-3 related to 2022 tax year compliance.

These new instructions, which are an update to a prior draft released in October, amend both the Domestic Filing Exception and Form 1116 Filing Exemption Exception to provide further leniency on who must complete the Schedule K-2 and K-3 in support of Form 1065 (U.S. Return of Partnership Income). While these instructions have been updated related to the Form 1065 only, we also expect a similar change to the instructions for Form 1120-S (Income Tax Return for an S Corporation).

Domestic Filing Exception

This exception focuses on the partnership or S Corporation providing notice to its partners or shareholders that no Schedule K-2 or K-3 will be provided. To qualify for this exception, the partnership or S Corporation must:

1. Have no or limited foreign activity.
2. Have only U.S.-filing individual partners (U.S. citizen/resident alien, certain trusts/estates, or S Corporation/LLCs with only one individual owner).
3. Notify partners or shareholders that no K-3 will be provided by the time the K-1 is provided
4. Receive no requests from a partner/shareholder no later than one month before the return is filed or one month before return due date.

This exception provides relief in completing the Schedule K-2 and K-3 for individual-owned partnerships and S Corporations that may not have previously used the information provided in completing their Form 1040. This exception does not grant relief to pass-through entities providing K-1s to other partnerships or corporations.

Form 1116 (Foreign Tax Credit) Filing Exemption Exception

This exception focuses on individuals providing notice to the partnership or S Corporation. To qualify for this exception:

1. The pass-through entity must have no or limited foreign activity.
2. All partners are not required to file a Form 1116.
3. The partnership or S Corporation must receive notice that no K-3 is needed no later than one month before the return is filed or one month before the return due date.

While this exemption from filing the K-2 will only apply if all partners or shareholders do not need to file a Form 1116, this exception provides further flexibility. If not all partners provide notice of this exemption, the pass-through entity must still complete the Schedule K-2, but only provide a Schedule K-3 to the individuals who have not provided any notice of exemption.

These exemptions will provide some relief to taxpayers and tax preparers by relieving this compliance burden for simple partnerships and S Corporations with individuals not requiring this information. However, pass-through entities with foreign activity or with partnerships or corporate partners or shareholders will still be required to complete these schedules.

If you have questions about these exemptions or their applicability to your tax filings, please reach out to your RKL tax advisor or the International Tax team.