Schedule K-2 and K-3 Filing Requirements
Fast Forward to the Present
Domestic Entity K-2/K-3 Filing Exception
Partner or Shareholder Notification
Where You Play a Role
Form 1116 – Foreign Tax Credit Filing Exception
Form 1116 Exception Entity Notification
There is an important issue related to filing the 2022 S-corporation (Form 1120-S) and partnership (Form 1065) tax returns that requires the cooperation of the shareholders and partners.
Background: The IRS, for the 2021 tax year, without sufficient warning, introduced two new schedules for S-corporations and partnerships, the Schedules K-2 and K-3. These two schedules are supplemental schedules to the Schedule K-1 that provides shareholders and partners with information that is needed to prepare their individual tax returns (Form 1040). Problem is these two new schedules were designed to report all forms of foreign transactions not just the ones that applied to the particular entity and were dealt with on supplemental schedules in the past. In fact, these two new schedules are both about 20 pages in length, which in turn substantially increases the return preparation time and preparation costs. As you might imagine this change created quite an uproar in the tax preparation community last filing season, and as a result the IRS provided some filing relief for certain 2021 returns.
Fast Forward to the Present – The IRS draft instructions for filing the 2022 S-corporation and partnership returns include two exceptions for filing the K-2 and K-3 Schedules for domestic S-corporations and partnerships. Unfortunately, and has become the norm for the IRS, the qualifications to use these exceptions are complicated.
Domestic Entity Exception – To use the domestic entity exception to avoid filing the Schedules K-2 and K-3, the entity can only have minimal foreign activity which is limited to passive income upon which no more than $300 of foreign tax was paid or accrued and reported on a U.S. information return. In addition all direct partners and shareholders must be U.S. citizens, resident aliens or certain domestic estates and trusts.
This Is Where You May Play a Role – Among other requirements, to qualify for the domestic filing exception each partner/shareholder must receive a notification from the entity along with the K-1 notifying the partner/shareholder that they will not receive a Schedule K-3 unless it is specifically requested. Generally unless involved in foreign transactions the K-3 is not required. If no partners/shareholders request a K-3 the partnership/S corporation is not required to complete and filed.
Form 1116 Exception – The IRS also provides an additional exception to filing Schedules K-2 and K-3 for domestic partnerships and S-corporations if all partners/shareholders qualify for the Form 1116 foreign tax credit filing exemption. The exemption from filing Form 1116 to claim foreign tax credit applies to individuals who have less than $300 ($600 for married couples filing jointly) in creditable foreign taxes paid on qualified passive foreign income. In other words, the partner or shareholder can claim a foreign tax credit without filing Form 1116. This exemption applies only if the foreign income is reported on a U.S. information return, such as a 1099-DIV, 1099-INT, 1099-B or a K-1. The downside to claiming the credit without using the Form 1116 is a taxpayer cannot make the election to claim any foreign tax credit carryovers.
For the Form 1116 exception to apply to the partnership or S-corporation, the entity must receive notification from all partners or shareholders no later than one month before the entity’s unextended filing deadline, which is February 15, 2023, for calendar-year partnerships and S-corporations. So don’t be surprised if the notification required for domestic entity exception also includes a request for the Form 1116 exception information.
Where the partnership or S-corporation is only advised by some of the shareholders or partners that they qualify for the Form 1116 exemption, then the entity need only complete the Schedules K-2 and K-3 for the other partners or shareholders to the extent that the entity does not qualify for the domestic filing exception.
Please contact this office if you have questions.
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