The IRS has now revised the draft Schedule K-2 and K-3 (Form 1065) instructions[1] issued on October 26, 2022, issuing a new draft Schedule K-2 and K-3 (Form 1065) instructions that make important changes to the domestic filing exception.  While no revised S corporation instructions have been issued as of the time this is being written, it seems likely similar changes will be made to those instructions.

Key Changes

The following are the key changes made to the domestic filing exception in the new revised draft instructions.

• The notice to partners no longer must be issued by January 15, 2023.  Rather, it can be issued as late as the date the Schedules K-1 are provided to the partners and even provided as an attachment to the Schedule K-1

• The 1-month date, for both the domestic filing exception and the Form 1116 exception, will now be one month before the Form 1065 is filed, so as late as August 15, 2023 for a calendar year partnership return placed on extension. one month before the due date for filing including extensions, which means it will move to August 15, 2023, if the partnership files for an automatic extension of time to file a calendar year return

• The list of US citizen/resident alien partners is now expanded to include S corporations with a single shareholder and single member LLCs owned whose owner is listed as an eligible US citizen/resident alien partner.

Domestic Filing Exception (as Revised in the December 2, 2022 Draft)

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.[2]  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.[3]

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.[4]

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.[5]

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). [6]

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;

(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)..[7]

The last two categories were added in the December 2, 2022 draft version of the form.

Note that a partnership with partnership or corporate partners (other than S corporations with a sole shareholder) will be barred from using this exception.  This is more restrictive than the 2021 FAQ Question 15 exception.

Partner Notification Requirement

The notification rules were made much more workable by the changes made in the December 2, 2022 draft of the instructions. No longer must this notice be sent to partners by January 15, 2022 for calendar year partnerships.

The instructions provide:

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. [8]

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 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. [9]

The December 2, 2022 instructions were modified to tie this to one month before the partnership files Form 1065. 

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 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 tax year 2022 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 1 month from the date on which the partnership receives the request from the partner. See Example 4. 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. [10]

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. 

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.[11]

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 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. See Examples 3 and 4.[12]

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 on an attachment to Schedule K-1 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.[13]

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 requests Schedule K-3 from USP for tax year 2022 and USP receives this request on February 1, 2023. After requesting an extension, 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 1-month date (July 31, 2023). 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.[14]

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 August 20, 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 tax year 2022 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 September 20, 2023, the later of the date on which USP files the Form 1065 or 1 month from August 20, 2023. Because A requested a Schedule K-3 for tax year 2022, USP must file tax year 2023 Schedules K-2 and K-3 with the IRS with respect to the information requested by A.[15]

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.[16]

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.[17]

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).[18]

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.[19]

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.[20]

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 6. 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 the 1-month date 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.[21]

[1] Partnership Instructions for Schedules K-2 and K-3 (Form 1065), Draft as of December 2, 2022, December 2, 2022, https://www.irs.gov/pub/irs-dft/i1065s23--dft.pdf (retrieved December 4, 2022)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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