Understanding Forms K-2 / K-3 For Tax Years 2021 & 2022
For the 2021 tax year, the IRS created Schedules K-2 and K-3 to provide consistency in reporting foreign activity for business owners of pass-through entities. This requirement would create unnecessary complexity and associated expenses for many closely held or family-owned small businesses. In response, the IRS provided an exception to filing the Forms for 2021 for certain domestic corporations, which was widely used by businesses that met the exception criteria.
IRS Draft Instructions Outline K-2/K-3 instructions
Based on the IRS draft instructions for Forms 1065 and 1120s released on October 25, 2022 and November 4, 2022, respectively, it looks like tax preparers and small businesses may be able to enjoy a similar exception for 2022. If approved in final drafts, this exception would be called the “Domestic Filing Exception.” This exception would be available to pass-through entities that qualify as a domestic partnership (entity) that meet the following four-part test:
1) No foreign activity or limited foreign activity.
- Limited foreign activity has its own three-part test:
- Foreign activity is passive, and
- Limited to not more than $300 in foreign income taxes without regard for the high-taxed income exception, and
- The foreign income (and taxes) is presented on a payee statement (i.e., a brokerage statement such as a 1099)
2) All partners are US Citizens or resident aliens; this includes domestic estates, grantor trusts, and non-grantor trusts
3) The partners must be notified that they will not receive a K-2/K-3 two months before the original (non-extended) filing date of the tax return.
4) No partners request the K-3 by at least one month before the original filing date of the return.
The overall theme of the (proposed) exception for 2022 is similar to the 2021 exception. However, the requirements to meet the exception are sharpened to include the additional communication requirement as outlined in (3) above. Therefore, it is important to review your client’s foreign activity annually during year-end planning and to assist with any necessary communication required to the business partners to meet the filing exception (if applicable).