The IRS on October 25, 2022, released a draft copy of the instructions for Schedules K-2 and K-3 of Form 1065 for 2022 tax returns.[1]  The draft contains a new formalized program for obtaining information from partners related to reporting on information that impacts information required to be provided to partners for possible use on Forms 1116 and 1118.

This release of the instructions was noted on the “Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865)” FAQ on the IRS website update on October 26, which read:

27. When will the 2022 draft instructions for the Schedules K-2 and K-3 be released and where can I find them? (added October 26, 2022)

On October 25, 2022, the IRS released drafts of the 2022 Partnership Instructions for Schedules K-2 and K-3 and the 2022 Partner’s Instructions for Schedule K-3 for the Form 1065.  In response to stakeholder input, the draft instructions provide a new filing exception as described on page 3 of the 2022 Partnership Instructions for Schedules K-2 and K-3. Comments on the draft instructions can be provided to lbi.passthrough.international.form.changes@irs.gov on or before November 8, 2022.[2]

The Form Will Still Need Attention by Most Practitioners

Unfortunately, at the top of page 3 is a statement that can easily again lead practitioners to believe they can simply ignore preparing and filing the form as a matter of course:

Note. Except as otherwise required by statute, regulations, or other IRS guidance, a partnership is not required to obtain information from its direct or indirect partners to determine if it needs to file each of these parts.[3]

This statement is so often contradicted by the instructions, which often require the partnership to presume an item is needed by a partner for his/her/its return in the absence of clear evidence it isn’t, that it should be ignored by practitioners—far too often a “must presume” standard will come into play, and this can only be discerned by carefully studying the detailed instructions for the various sections.

Domestic Filing Exception

The sections that created the most problems for domestic partnerships involved items related to information that might be necessary for partners related to reporting foreign tax credit items.  In the “What’s New” section of the instructions, the IRS announces they have added a domestic filing exception this year.

This exception is a modification of the special relief offered for 2021 filings in Question 15 of the “Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865)” published on February 16, 2022, on the IRS website.[4]  The instructions describe the new exception as follows:

New exception to completing Schedules K-2 and K-3. These instructions add a new exception for filing and furnishing Schedules K-2 and K-3 for tax years beginning in 2022. See the domestic filing exception.[5]

The instructions do repeat the guidance from the prior year’s instructions that warns that even some partnerships with no foreign activities may nevertheless need to complete the forms:

Note. A partnership with no foreign source income, no assets generating foreign source income, no foreign partners, and no foreign taxes paid or accrued may still need to report information on Schedules K-2 and K-3. For example, if the partner claims a credit for foreign taxes paid or accrued by the partner, the partner may need certain information from the partnership to complete Form 1116 or 1118. Also, a partnership that has only domestic partners may still be required to complete Part IX when the partnership makes certain deductible payments to foreign related parties of its domestic partners.

The information reported in Part IX will assist any domestic corporate partner in determining the amount of base erosion payments made through the partnership, and in determining if the partners are subject to the base erosion and anti-abuse tax (BEAT).

Further, if the domestic partnership with no foreign activity or foreign partners has direct or indirect domestic corporate partners, Part IV (concerning foreign-derived intangible income (FDII)) may need to be completed.

 A domestic or foreign publicly traded partnership as defined in section 7704(b) (PTP) with no foreign activity or foreign partners may need to complete Part XI. See each part for applicability.[6]

But following an example dealing with the base erosion and anti-abuse tax (BEAT), something most practitioners will not be dealing with, it does describe the new domestic filing exception, beginning by outlining the benefits of meeting this exception:

Domestic filing exception (exception to filing Schedules K-2 and K-3). A domestic partnership (as defined under section 7701(a)(2) and (4)) does not need to (a) complete and file with the IRS the Schedules K-2 and K-3, or (b) furnish to a partner the Schedule K-3 (except where requested by a partner after the 1-month date (defined in criteria number 4, below)) if each of the following four criteria are met with respect to the partnership’s tax year 2022.[7]

Foreign Activity Test

The first criteria to meet relates to foreign activities:

1. No or limited foreign activity. During a domestic partnership’s tax year 2022, the domestic partnership either has no foreign activity (as defined below), or, if it does have foreign activity, such foreign activity is limited to

(a) passive category foreign income (determined without regard to the high-taxed income exception under section 904(d)(2)(B)(iii));

(b) upon which not more than $300 of foreign income taxes allowable as a credit under section 901 are treated as paid or accrued by the partnership; and

(c) such income and taxes are shown on a payee statement (as defined in section 6724(d)(2)) that is furnished or treated as furnished to the partnership.

Foreign activity. For purposes of the domestic filing exception, foreign activity means any of the following.

(a) foreign income taxes paid or accrued (as defined in section 901 and the regulations thereunder);

(b) foreign source income or loss (as determined in sections 861 through 865, and section 904(h), and the regulations thereunder);

(c) ownership interest in a foreign partnership (as defined in sections 7701(a)(2) and (5));

(d) ownership interest in a foreign corporation (as defined in sections 7701(a)(3) and (5));

(e) ownership of a foreign branch (as defined in Regulations section 1.904-4(f)(3)(vii));

(f) ownership interest in a foreign entity that is treated as disregarded as an entity separate from its owner (as defined in Regulations section 301.7701-3).[8]

One key change from the 2021 FAQ is that there is a de minimis foreign activity provision if the partnership has a very minor amount of foreign taxes withheld on stocks, mutual funds, and the like.

US Citizen/Resident Alien Partner Test

The next criteria requires that all direct partners must meet certain criteria:

2. U.S. citizen/resident alien partners. During tax year 2022, all the direct partners in the domestic partnership are:

(a) individuals that are U.S. citizens;

(b) individuals that are resident aliens (as defined in section 7701(b)(1)(A) and the regulations thereunder);

(c) domestic decedent’s estates (that is, decedent’s estates that are not foreign estates as defined in section 7701(a)(31)(A)), with solely U.S. citizen and/or resident alien individual beneficiaries;

(d) domestic grantor trusts (that is, trusts described under sections 671 through 678) that are not foreign trusts as defined in section 7701(a)(31)(B)) and that have solely U.S. citizen and / or resident alien individual grantors and solely U.S. citizen and / or resident alien individual beneficiaries; or

(e) domestic non-grantor trusts (that is, trusts subject to tax under section 641 that are not foreign trusts as defined in section 7701(a)(31)(B)) with solely U.S. citizen and/or resident alien individual beneficiaries.[9]

Note that a partnership with partnership or corporate partners will be barred from using this exception.  This is more restrictive than the 2021 FAQ Question 15 exception.

Partner Notification Requirement

The test that requires the most work by advisers and their clients is the new partner notification requirement due to the strict rules on dates by which such notifications must be provided.

The instructions provide:

3. Partner notification. With respect to a partnership that satisfies criteria 1 and 2, partners receive a notification from the partnership either electronically or by mail dated no later than 2 months before the due date (without extension) for filing the partnership’s tax year 2022 Form 1065. The notification must state that partners will not receive Schedule K-3 from the partnership unless the partners request the schedule.[10]

This due date requirement means that the partners’ notices must be sent by no later than January 15 to meet the two-month requirement for calendar year partnerships.  Advisers will likely need to begin notifying clients soon about this requirement if the partnership wishes to attempt to make use of this exception unless the IRS provides relief from this requirement in the final instructions. 

However, those final instructions may be released much closer to that January 15 date, so prudence suggest assuming such notices need to be issued and preparing to insure they are timely issued.

Partner Request Received by the “1-Month Date”

The final test looks to see if any partners return requests to have the form issued by what is referred to as the 1-month date:

4. No 2022 Schedule K-3 requests by the 1-month date. The partnership does not receive a request from any partner for Schedule K-3 information on or before the 1-month date. The “1-month date” is one month before the due date (without extension) of the partnership’s Form 1065. For tax year 2022 calendar year partnerships, the 1-month date is February 15, 2023. (emphasis added)[11]

The instructions go on to provide information on what the partnership still must do if it receives such a request after the 1-month date.

Note. If a partnership receives a request from a partner for the Schedule K-3 information after the 1-month date and has not received a request from any other partner for Schedule K-3 information on or before the 1-month date, the domestic filing exception is met and the partnership is not required to file the Schedules K-2 and K-3 with the IRS or furnish the Schedule K-3 to the non-requesting partners. However, the partnership is required to provide the Schedule K-3, completed with the requested information, to the requesting partner on the later of the date on which the partnership files the Form 1065 or one month from the date on which the partnership receives the request from the partner. See Example 4.[12]

Under the 2021 FAQ Question 15 exception, the key date was the date the return was filed by the partnership, so that any notice of a need for the information prior to the actual filing of the return meant the exception was not met.  Under this rule, it appears that even if the partnership files for an extension of time to file its return and finally files that return on September 15, it can still escape having to file Schedule K-2 with its return even if it received a notice from a partner needing the information on February 16.

If a partnership does receive notification by the 1-month date, the instructions provide:

Note for partnerships that satisfy criteria 1 through 3, but do not satisfy criterion 4. If the partnership received a request from a partner for Schedule K-3 information on or before the 1-month date and therefore the partnership does not satisfy criterion 4, the partnership is required to file the Schedules K-2 and K-3 with the IRS and furnish the Schedule K-3 to the requesting partner. The Schedules K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting partner.

For example, if a partner requests the information reported on Part III, Section 2 (Interest Expense Apportionment Factors), the partnership is required to complete and file Schedule K-2, Part III, Section 2 with respect to the partnership’s total assets and Schedule K-3, Part III, Section 2 with respect to the requesting partner’s distributive share of the assets. On the date that the partnership files Schedules K-2 and K-3 with the IRS, the partnership must provide a copy of the filed Schedule K-3 to the requesting partner.

The partnership does not need to complete, attach, file, or furnish any other parts or sections of the Schedules K-2 and K-3 to the IRS, the requesting partner, or any other partner. The partnership should keep records of the information requested by the partner. See Example 3.[13]

If this partnership later receives requests from other partners after the 1-month date, the instructions state:

If a partnership receives requests from partners for Schedule K-3 information both on or before the 1-month date and after the 1-month date, the partnership is required to file Schedules K-2 and K-3 as described in the prior paragraph only with respect to the partner requests received on or before the 1-month date. With respect to requests received after the1-month date, the partnership is required to provide the Schedule K-3, completed with that partner’s requested information, on the later of the date on which partnership files the Form 1065 or one month from the date on which the partnership receives the request from the partner. See Example 5.[14]

Examples for the Domestic Filing Exception

The instructions provide a series of examples of applying this rule.  The first example looks at a partner who receives only a minor amount of foreign taxes reported to it on a Form 1099DIV from a mutual fund:

Example 2. Husband and wife, U.S. citizens, each own a 50% interest in USP, a domestic partnership. USP and husband and wife each have a tax year end of December 31. USP invests in a regulated investment company (RIC). With respect to tax year 2022, USP receives a Form 1099 from the RIC reporting $100 of creditable foreign taxes paid or accrued on passive category foreign source income. USP does not have any foreign activity other than that from the RIC. Husband and wife receive notification from USP dated January 10, 2023, that they will not receive the Schedule K-3 unless they so request. Husband and wife do not request Schedule K-3 from USP for tax year 2022. USP qualifies for the domestic filing exception, and, as such, USP need not complete Schedules K-2 and K-3.[15]

The next example adds a case where there is another partner who does require certain information on Schedule K-3 and gives noticed by the 1-month date:

Example 3. The facts are the same as in Example 2 except that husband and wife each own a 40% interest in USP, and A, a U.S. citizen, owns a 20% interest in USP. A receives notice from USP dated January 10, 2023, that A will not receive the Schedule K-3 unless A so requests. A requests Schedule K-3 from USP for tax year 2022 and USP receives this request on February 1, 2023. USP does not qualify for the domestic filing exception because A requested the Schedule K-3 by the 1-month date. As such, USP must complete and file with the IRS the parts and sections of the Schedules K-2 and K-3 that are relevant to A. With respect to the Schedules K-2 and K-3 filed with the IRS, USP does not need to complete, attach, or file any parts or sections relevant to husband and wife. USP must provide a copy of the filed Schedule K-3 to A on the date that USP files its Form 1065. USP does not need to furnish a Schedule K-3 to husband and wife.[16]

The next example uses the same facts, except the request is received after the 1-month date:

Example 4. The facts are the same as in Example 3 except that USP receives the request from A on February 20, 2023. USP files Form 1065 on August 31, 2023. USP qualifies for the domestic filing exception because A requested the Schedule K-3 after the 1-month date. USP is not required to file the Schedules K-2 and K-3 with the IRS or furnish the Schedule K-3 to husband and wife. However, USP is required to provide the Schedule K-3, completed with the requested information, to A on August 31,2023, the later of the date on which USP files the Form 1065 or one month from February 20, 2023.[17]

The final example goes back to Example 3’s facts (where A requested the information by the 1-month date) but now has the husband and wife request the information after the 1-month date:

Example 5. The facts are the same as in Example 3 except that husband and wife request the Schedule K-3 and USP receives the request on February 20, 2023. USP files Form 1065 on August 31, 2023. USP does not qualify for the domestic filing exception because A requested the Schedule K-3 by the One-Month Date. As such, USP must complete and file with the IRS the parts and sections of the Schedules K-2 and K-3 that are relevant to A. With respect to the Schedules K-2 and K-3 filed with the IRS, USP does not need to complete, attach, or file any parts or sections relevant to husband and wife. USP must provide a copy of the filed Schedule K-3 to A on August 31, 2023. USP is required to provide a Schedule K-3, completed with the information requested by husband and wife, to husband and wife on August 31, 2023, the later of the date on which USP files the Form 1065 or one month from February 20, 2023.[18]

The Form 1116 Exemption

The instructions provide for a second exception to completing the forms related to foreign tax credit issues in the Form 1116 exemption.  The draft notes at the end of the instructions for the domestic filing exception that:

Note. If a partnership does not meet the domestic filing exception, it may meet the Form 1116 Exemption to filing the Schedules K-2 and K-3. See below.[19]

That exception is described at page 10 of the instructions:

Form 1116 exemption exception. Under section 904(j), certain partners are not required to file a Form 1116 (“Form 1116 exemption”). Also see Foreign Tax Credit—How To Figure the Credit.[20]

IRC §904(j) reads, in part:

(j) Certain individuals exempt

(1) In general

In the case of an individual to whom this subsection applies for any taxable year—

(A) the limitation of subsection (a) shall not apply,

(B) no taxes paid or accrued by the individual during such taxable year may be deemed paid or accrued under subsection (c) in any other taxable year, and

(C) no taxes paid or accrued by the individual during any other taxable year may be deemed paid or accrued under subsection (c) in such taxable year.

(2) Individuals to whom subsection applies

This subsection shall apply to an individual for any taxable year if—

(A) the entire amount of such individual’s gross income for the taxable year from sources without the United States consists of qualified passive income,

(B) the amount of the creditable foreign taxes paid or accrued by the individual during the taxable year does not exceed $300 ($600 in the case of a joint return), and

(C) such individual elects to have this subsection apply for the taxable year.

This is the exemption available to individuals who receive their entire amounts of creditable foreign tax and income as foreign tax credit passive income (generally interest and dividends) reported to them on Forms 1099, trust and estate K-1s, partnership K-3s and S corporation K-3s that allows them to claim the entire amount of tax as a credit without computing the detailed limitations on the credit on Form 1116.  The amount of tax is simply reported as a tax credit on Schedule 3, Form 1040.

The instructions continue:

A domestic partnership is not required to complete Schedules K-2 and K-3 if all partners are eligible for the Form 1116 exemption and the partnership receives notification of the partners’ eligibility for such exemption by the 1-month date (as defined above).[21]

Note that the 1-month date again becomes relevant, though this time the partnership must receive the notification from the partner by the 1-month date in order to take advantage of this exception—otherwise the partnership is going to be required to treat the information as needed by all partners for which the notification is not received.

If a partnership receives notification from only some of the partners that they are eligible for the Form 1116 exemption, the partnership need not complete the Schedule K-3 for those exempt partners but must complete the Schedules K-2 and K-3 with respect to the other partners to the extent that the partnership does not qualify for the domestic filing exception.[22]

The instructions make this point clear later, noting:

A partnership that does not have or receive sufficient information or notice regarding a direct or indirect partner must presume such partner is eligible to claim a foreign tax credit and such partner would have to file a Form 1116 or Form 1118 to claim a credit. As such, the partnership must complete the Schedules K-2 and K-3, including Parts II and III, accordingly.[23]

One interesting item to note about this additional instruction is that it mentions the partnership having or receiving “sufficient information” related to the lack of need for this data in addition to the previously described notice.  It’s not clear if this means that a partnership could avoid the 1-month date notification problem by receiving other information confirming that the partner will not have to file a Form 1116 or Form 1118, and thus avoid preparing the Schedules K-2 and K-3 parts II and III.

The IRS does provide an example of applying the Form 1116 exemption exception:

Example 7. Husband and wife, U.S. citizens, each own a 50% interest in USP, a domestic partnership. Husband and wife and USP each have a calendar tax year.

USP invests in a RIC. USP receives a Form 1099 from the RIC reporting $400 of creditable foreign taxes paid or accrued on passive category foreign source income. USP’s only foreign activity is that from the RIC.

Husband and wife do not pay or accrue any foreign taxes other than their distributive share of USP’s foreign taxes. Husband and wife also do not have any other foreign source income. Husband and wife qualify for the Form 1116 exemption and notify USP by February 15, 2023, that they do not need the Schedule K-3.

Even though USP does not qualify for the domestic filing exception because the creditable foreign taxes treated as paid or accrued by USP are greater than $300, because husband and wife notify USP by the 1-month date that they do not need the Schedule K-3 under the Form 1116 exemption, USP need not complete Schedules K-2 and K-3.[24]

No S Corporation Instructions Yet

As of the date this article was written (October 29, 2022) the IRS had not yet released the draft S Corporation Schedules K-2 and K-3 instructions for 2022.  While likely such instructions will contain similar options, we can’t know for sure until those draft instructions are issued.

[1] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, https://www.irs.gov/pub/irs-dft/i1065s23--dft.pdf

[2] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), IRS Website, October 26, 2022, https://www.irs.gov/businesses/schedules-k-2-and-k-3-frequently-asked-questions-forms-1065-1120s-and-8865

[3] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[4] Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865), IRS Website, October 26, 2022

[5] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 1

[6] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[7] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[8] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[9] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[10] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[11] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3

[12] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 3-4

[13] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[14] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[15] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[16] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[17] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[18] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[19] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 4

[20] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 10

[21] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 10

[22] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 10

[23] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 10

[24] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of October 25, 2022, October 25, 2022, p. 10