The IRS posted the final version of the 2022 partnership Schedule K-2 and K-3 instructions to their 2022 forms site on December 28, 2022.[1] No changes appear to have been made to the Domestic Filing Exception when compared to the second draft version of the instructions that were issued in early December.

Domestic Filing Exception

The domestic filing exception is explained beginning on page 3 of the 2022 instructions.

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.[2]

No or Limited Foreign Activity

The first criteria that must be met is that the partnership must have no or limited foreign activity.  For these purposes, foreign activity is defined as:

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

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

• Ownership interest in a foreign partnership (as defined in sections 7701(a)(2) and (5));

• Ownership interest in a foreign corporation (as defined in sections 7701(a)(3) and (5));

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

• 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).[3]

The instructions provide the following information about meeting this criterion:

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

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

• 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

• 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.[4]

US Citizen/Resident Alien Partners

Assuming the partnership met the first criteria, the next test looks at the partners of the partnership.  All direct partners of the partnership must be contained on the list found in the instructions.

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;

(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;

(f) S corporations with a sole shareholder; or

(g) single-member LLCs, where the LLC’s sole member is one of the persons in subparagraphs (a) through (f), and the LLC is disregarded as an entity separate from its owner (as defined in Regulations section 301.7701-3).[5]

When these instructions were not issued at the same time as the final instructions for S Corporation Form K-2 and K-3 instructions, it seemed possible that the IRS might be working on a revision of this list to allow at least some additional entities.  However, the final list is the same list found on the early December draft version of these instructions.

Partner Notification

A partnership that meets the first two criteria must next issue notices to the partners advising each that the partnership does not plan to issue a Schedule K-3 to the partner unless the partner specifically requests that schedule. Like the early December instructions, the final instructions allow this notice to be issued to the partners as late as the Schedules K-1 are issued to the partners.  The instructions also explicitly allow this notice to be sent as an attachment to the Schedules K-1.

3. Partner notification. With respect to a partnership that satisfies criteria 1 and 2, partners receive a notification from the partnership at the latest when the partnership furnishes the Schedule K-1 to the partner. The notice can be provided as an attachment to the Schedule K-1. The notification must state that partners will not receive Schedule K-3 from the partnership unless the partners request the schedule.[6]

Note that this means that if a partnership files for an extension of time to file its return and does not file the return until the last date allowed per the extension, the partners would not need to receive their K-1s (and thus the notice) until September 15, 2023.

No 2022 Schedule K-3 Requests by the 1-Month Date

Assuming the first three criteria have been met, the last criteria provides that the partnership will not need to file a Schedule K-2 or the partners’ Schedules K-3 with its return, nor provide such Schedules K-3 to the partners at the time they receive their K-1s, unless the partnership receives a request from a partner to receive a Schedule K-3 by the date that is one month before the date the partnership files its tax return (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 1 month before the date 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.[7]

K-3 Requests Received After the 1-Month Date

While meeting the four criteria relieves the partnership from having to file the Schedule K-2 and partners Schedules K-3 with its tax return, the partnership may still need to prepare Schedules K-3 for individual partners.  The forms will need to be prepared (though not sent to the IRS, either via an amendment to the return or an administrative adjustment request) if any partner makes such a request for the form after the 1-month date.

The instructions provide:

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 tax year 2022 Schedules K-2 and K-3 with the IRS or furnish the tax year 2022 Schedule K-3 to the non-requesting partners.

However, the partnership is required to provide the tax year 2022 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 1 month from the date on which the partnership receives the request from the partner[8]

It’s not clear how a partnership could be filing its Form 1065 more than 1 month after the partner requests the Schedule K-3, but the partner still have failed to make the request before the 1-month date.  So, for practical purposes the Schedule K-3 will need to be provided to the partner within one month of the date of his/her late request.

However, this late request will have an impact on the 2023 filings, as the partnership will need to prepare a Schedule K-3 for this partner in 2023 and send that form to the IRS along with the partnership wide Schedule K-2 form.  The instructions state:

The partnership must complete and file tax year 2023 Schedules K-2 and K-3 with respect to the requesting partner by the tax year 2023 Form 1065 filing deadline.[9]

When Only Some Partners Request a Schedule K-3 by the 1-Month Date

The instructions provide additional directions for what happens when some, but not all, partners request a Schedule K-3 by the 1-month date and all other criteria for the Domestic Filing Exception have been met.  In this case, the partnership will obtain some relief as noted below:

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.[10]

Again, if the partnership now receives additional requests from other partners after the 1-month date, while it still provides these Schedules K-3 to the requesting partners, it does not provide them to the IRS nor file any sort of revised partnership return to add this information to the return filed with the agency:

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 the 1-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 1 month from the date on which the partnership receives the request from the partner.[11]

No Requirement the Notice Must Be Given Before the 1-Month Date

I have noted some commentators have suggested that the rules outlined above still require that the notice to partners be sent out prior to the 1-month date.  However, nothing in the instructions either requires or even implies that the notice must be given before that date.  As well, some have stated that any request received prior to August 15, 2023, would require filing Schedules K-2 and K-3 with the return filed with the IRS.

Nothing in the instructions themselves contain any requirement that the notice be given before the 1-month date.  In fact, as noted earlier, the instructions would allow providing the notice with a K-1 issued to the partner on September 15, 2023, with a return filed on that date.  September 15, 2023 would be, per the instructions themselves, after the final possible 1-month date for a 2022 calendar year return.

What seems to cause some confusion for those who believe that any request before August 15, 2023, requires filing the forms with the return sent to the IRS is the statement in the instructions that “For tax year 2022 calendar year partnerships, the latest 1-month date is August 15, 2023, if the partnership files an extension.” But notice this merely says the latest 1-month date for a calendar year partnership is August 15, 2023 (and then only for a partnership that obtains an extension of time to file its return), not that this is the 1-month date for all partnerships.

As well, it seems unlikely that anyone who had not read the October draft instructions would conclude that there is any “advance notice” requirement at all.  Those instructions mechanically required a notice to be issued by January 15 and set the 1-month date at February 15—but the second draft and the final instructions eliminated those specific dates.

Based on the instructions themselves, the following example appears to be a perfectly acceptable way for a partnership to move forward

EXAMPLE

ABC partnership has two partners, Jeffrey and Renee, both U.S. citizens.  The partnership has a single rental property located in Gila Bend, Arizona.  The partnership has no foreign activities of any sort.

On March 1, 2023, the partnership files its 2022 Form 1065 and provides Schedules K-1 to each partner.  As of February 1, 2023 (one month before the return was filed) neither partner had requested a Schedule K-3 from the partnership.  If the partnership attaches a statement that the partnership will not be providing a Schedule K-3 unless the partner requests it to each partner’s K-1, the partnership will have fulfilled all requirements to make use of the Domestic Filing Exception for 2022.  Thus, the Form 1065 submitted to the IRS will not contain a Schedule K-2, nor will it have a Schedule K-3 included for either partner with that return sent to the IRS.

On April 1, Jeffrey notifies the partnership that he will need a Schedule K-3 from the partnership to complete his return.  The partnership must provide Jeffrey with a Schedule K-3 by May 1, 2023.  However, the partnership does not submit that Schedule K-3 to the IRS, does not prepare a Schedule K-2 and does not file an amended return or administrative adjustment request with the IRS to provide the agency with this information.

For 2023 the partnership will be required to prepare a Schedule K-3 for Jeffery with its original return due to his late request for that information for 2022.

[1] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022, https://www.irs.gov/pub/irs-pdf/i1065s23.pdf (retrieved December 29, 2022)

[2] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[3] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[4] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[5] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[6] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[7] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[8] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[9] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[10] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022

[11] 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), IRS website, December 28, 2022