On December 5, 2022, the IRS released the updated draft of 2022 Schedules K-2 and K-3 and accompanying instructions providing details on the filing relief for “domestic only” partnerships. The newest release updates the problematic due dates for both partner notifications and requests that were part of the previous October 2022 draft instructions and forms.
Most partnerships, namely those with foreign source activity, who have foreign partners, foreign taxes paid or accrued, or maintain assets generating foreign source income should expect to continue filing Schedules K-2 and K-3 for tax year 2022. The updated instructions, however, provide partnerships with substantially all domestic activity clarity in their reporting obligations. These “domestic only” partnerships were in tax limbo when Schedules K-2 and K-3 were initially released last year as they did not appear to fit the mold for the reporting the IRS was looking for.
To qualify for the domestic filing exceptions under the initial instructions released for the 2021 tax year, the partnership needed to have direct partners that were U.S.-based, no current year foreign activity, no prior year foreign information provided on Schedule K-1 (Line 16), and no knowledge that the partners were requesting Schedule K-3 information.
For 2022, the rules to qualify for the domestic filing exception have been clarified – the following four criteria must be met:
- No or Limited Foreign Activity
- The partnership has no foreign activity or only has foreign passive activity upon which $300 or less of foreign income taxes were paid or accrued.
- Foreign activity refers to any of the following: foreign income taxes paid or accrued, foreign source income or loss, ownership interest in a foreign partnership, ownership interest in a foreign corporation, ownership of a foreign branch, or ownership interest in a foreign entity that is treated as a disregarded entity separate from its owner.
- U.S. Citizen/Resident Alien Partners
- During the 2022 tax year, all direct partners must be one of the following:
- U.S. citizens
- Resident aliens
- Domestic decedent’s estate
- Domestic grantor trust
- Domestic non-grantor trust
- S Corporations with a sole shareholder
- Single Member LLCs where the LLC’s sole member is one of the persons described above
- Partner Notification
- Assuming a partnership meets the first two criteria, a notice or notification must be sent to all partners no later than the date the partnership furnishes the Schedule K-1 to the partner. The IRS has allowed, via the latest update of the instructions, that 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.
If a partnership does not notify the partners, it would be required to prepare and file the 2022 Schedules K-2 and K-3 with Form 1065.
- No 2022 Schedule K-3 Requests by the 1-month date
- The partnership must not receive a request from any partner for Schedule K-3 information on or before one month prior to the date the partnership files the extended Form 1065. The latest possible one-month date for calendar-year partnerships is August 15, 2023.
- If a request is received on or before the one-month date, the partnership must file Schedules K-2 and K-3 and attach them to the tax return. As with all Schedules K-2 and K-3, only the relevant parts or sections of the form must be completed; the partnership does not need to complete sections that are not relevant or requested by the partner.
- If a partnership receives a request from a partner for the Schedule K-3 information after the one-month date and has not received a request from any other partner for Schedule K-3 information on or before the one-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.
Industrywide, practitioners spent countless hours adjusting internal processes to account for the increased reporting requirements and navigating the 2021 Schedule K-2 and K-3 landscape. The updated 2022 instructions make it very clear that reporting remains dependent upon an entity-by-entity analysis; one-size does not fit all.
Several points of note on the updated exception detailed above:
- While prior year activity mattered for the 2021 domestic filing exception, it is not relevant for qualification for the 2022 filing exception; only current year activity is to be analyzed.
- The “no knowledge that partners were requesting Schedule K-3 information” requirement for 2021 is replaced by the notice and one-month requirement. This takes any ambiguity out of the process and provides clear dates and deadlines for notification and requests by both the partnership and partners.
- The threshold for foreign activity is markedly low and it must be passive in nature. Particularly where larger clients have substantial holdings under management and in the fund-of-fund space, this test is nearly impossible to pass.
- U.S. Citizens/Resident Alien partners notably exclude multi-member pass-through entities and corporations. The December update to the instructions expanded this section of the qualifications to include single-member LLCs, as well as S corporations with a sole shareholder – a well-received expansion of the rules. Fund-of-funds, tiered structures, and other larger partnerships often have pass-through and corporate partners making this exception another hard test to pass. Partnership and fund managers must take extra steps to know their investor base, their investor tax classifications, and have all relevant information collected and on file.
- The partner notifications and one-month requests, as set out in the originally released draft instructions from October 2022, pushed the tax season forward in such a way that January 15 and February 15 became almost more important than the actual filing deadline. Entities and their tax preparers would have to have started work before year-end to ensure the proper communications are received on time by all partners and documented to ensure full compliance by all parties. The change in the instructions as apparent in the December draft shows that the IRS heard practitioner comments and adjusted accordingly. Notices can now be mailed out with Schedules K-1 and the request deadline now accounts for extensions – a welcome update!
- Follow-up regarding one-month requests becomes critical to ensure preparers and providers have adequate time to provide requested information. Essentially, a one-month request enhances the scope of filing, and this process should not be discounted.
Though these instructions are only in draft form, they represent a move in the right direction; clarity for partners, clarity for partnerships/managers, and clarity for tax preparers. We will yet again see changes this season in internal process and communications with investors and tax providers – all necessary to make sure compliance is completed correctly.
Communication and documentation are our watchwords for this upcoming tax season. The flow-through and international teams at Wolf & Company will continue to monitor all releases in this space.
Please reach out to your engagement teams with any questions on this evolving matter.
RITA RYAN, J.D., LL.M.
Senior Manager, International Tax Services Team Lead
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +1(617) 419-4202
KRISTIN L. STONE, CPA, MST
Principal, Flow-Through Tax Team Lead
Wolf & Company, P.C.
255 State Street, Boston, MA 02109
Direct +1 (617) 428-5464