Domestic filing exception requirements modified in draft Scheds. K-2, K-3

By Martha Waggoner

The IRS last Friday posted a revised draft version of the 2022 Partnership Instructions for Schedule K-2 and K-3 (Form 1065) and, on Monday, it posted a similar revised version of the 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S). The key difference in these draft instructions from a first set of draft instructions for the forms posted in October 2022 is that new draft instructions modify the requirements to qualify for the domestic filing exception for filing and furnishing partnership and S corporation Schedules K-2 and K-3.

Domestic filing exception

The original draft instructions for 2022 partnership and S corporation Schedules K-2 and K-3, posted in October, contained a new exception to the requirement that partnerships and S corporations file and furnish the schedules for tax years beginning in 2022 (a similar exception was offered by the IRS in 2021 in Question 15 of the "Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865)"). Partnerships would qualify for this domestic filing exception if:

  1. The partnership has no or limited foreign activity;
  2. The partnership's direct partners are certain specified U.S. citizens/resident aliens;
  3. Partners in the partnership receive a notification from the partnership by Jan. 15, 2023, stating that partners will not receive Schedule K-3 unless they request it; and
  4. The partnership does not receive any 2022 Schedule K-3 requests by the one-month date, which is defined as one month before the due date (without extension) of the partnership's Form 1065, U.S. Return of Partnership Income.

A similar domestic filing exception was included in the October draft instructions for S corporation Schedules K-2 and K-3, but it did not contain requirement number 2.

Under requirement 2 in the October draft instructions, the U.S. citizens/resident aliens who are allowed to be direct partners were: (a) individuals who are U.S. citizens; (b) individuals who are resident aliens; (c) domestic decedent's estates with solely U.S. citizen and/or resident alien individual beneficiaries; (d) domestic grantor trusts that are not foreign trusts as defined in Sec. 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; and (e) domestic nongrantor trusts with solely U.S. citizen and/or resident alien individual beneficiaries.

Changes to domestic filing exception in December draft Instructions

The domestic filing exception, with the same four general requirements, is retained in the new December draft partnership instructions for Schedules K-2 and K-3. However, certain specific details of the requirements have been modified in the new draft instructions.

The December draft instructions expand the list of allowable direct partners to include S corporations with a sole shareholder and certain single-member limited liability companies (LLCs) that are disregarded as an entity separate from their owner.

The December draft instructions also change the date the notification in requirement 3 must be provided to the partners. The date has been changed from Jan. 15, 2023, to, at the latest, when the partnership furnishes Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., to the partner, and the notice can be provided as an attachment to Schedule K-1.

In addition, the December draft instructions change the one-month date in requirement 4. The one-month date is now one month before the partnership files Form 1065. In the October draft instructions, the one-month date was one month before the due date (without extension) of the partnership's Form 1065.

Similar changes to requirements 3 and 4 are included in the new December draft S corporation instructions for Schedules K-2 and K-3.

AICPA letter on Schedules K-2 and K-3 draft instructions

Several days before the release of the December draft instructions, the AICPA sent a letter to the IRS commenting on the Schedule K-2 and Schedule K-3 2022 draft instructions, as they then existed. In that letter, the AICPA recommended that partners notify partnerships of their international interests, as the IRS does in other areas, rather than the other way around.

The reporting requirements of Schedules K-2 and K-3 "continue to create significant costs and administrative burdens" for the businesses that file them, says the AICPA letter, dated Nov. 30.

Starting in the 2021 tax year, passthrough entities (PTEs) had to report items of international tax relevance on Schedule K-2 and provide their partners' and shareholders' share of these items on Schedule K-3.

Before the form instructions were released, many practitioners understood that these schedules were required only when the taxpayer had foreign operations or the taxpayer had reason to know that it had a direct or indirect foreign partner, the AICPA letter says.

But the 2021 instructions "make clear that most taxpayers must comply with these information reporting requirements, regardless of their lack of foreign operations or foreign partners," says the letter, signed by Jan Lewis, CPA, chair of the AICPA Tax Executive Committee.

The AICPA's November letter, which recommends changes in six areas, follows comments that the AICPA submitted in February advising that the Schedule K-2 and K-3 requirements were too broad and too burdensome for taxpayers that did not have items of international tax significance. The IRS then issued answers to frequently asked questions, including an additional exception for tax year 2021 (FAQ15).

The October draft instructions combined the post-release changes to the 2021 instructions and the FAQs, along with some comments from the AICPA that were not previously part of the guidance. These 2022 instructions replaced FAQ15 with a new exception for domestic partnerships, known as the domestic filing exception.

Partnership notification

The partnership notification requirement in the domestic filing exception requires the PTE to notify partners that they will not receive Schedule K-3 from the partnership unless the partners request the schedule. The AICPA letter recommends that the IRS follow the lead of other forms that the agency uses and require partners to notify the partnership which parts of Schedule K-3 they require.

"Partners should be required to notify the partnership which sections of Schedule K-3 they require and allow the partnership to determine which filing exceptions it qualifies for based on this information and the activity of the partnership," the letter says.

In other situations, including Schedules K, Foreign Tax Carryover Reconciliation Schedule, and K-1, the onus of notification falls on the partner to notify the partnership "when certain niche information is required to be reported based on the tax attribute of the partner," the letter says. "The requirement of certain items of international relevance is similarly niche in nature, and so the burden of notification should similarly fall to the partner."

Additional recommendations

In addition to recommendations regarding the domestic filing exception, the AICPA recommended changes in these areas:

  • Allowing partnerships subject to the Bipartisan Budget Act of 2015, P.L. 114-74, to amend 2021 Schedules K-2 and K-3;
  • Addressing the receipt of foreign activity sourced to "various" or "other country";
  • Preventing reapportionment of interest expense;
  • Modifying Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI), to report gross income instead of net income for purposes of determining FDII; and
  • Miscellaneous clarifications and recommendations.

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.

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