IRS Revises Exception for Schedules K-2 and K-3

As discussed on pages 27 through 30 of the Tax Year 2022 M+O=CPE Individual Tax Year-End Workshop Reference Book, Schedules K-2 and K-3 were introduced by the IRS for the 2021 tax year for entities to report international/foreign tax information to owners. The IRS surprised many by requiring that certain entities file Schedules K-2 and K-3, even though they have no foreign activities.

IRS Notice 2021-39 provided broad relief from this requirement for the 2021 tax year, but this broad relief is not expected to be available again for later tax years, based on the draft instructions for Schedules K-2 and K-3 issued by the IRS for the 2022 tax year.

The November 2022 version of those draft instructions set forth four criteria for an entity to meet the domestic filing exception and not be required to file Schedules K-2 and K-3. As part of the eligibility for this exception, the November draft stipulated that entities must send certain required notices to their owners no later than 2 months before the due date of the entity’s 2022 return (without extension). It also gave owners until 1-month before the due date of the entity’s 2022 return (without extension) to respond to those notices.

On December 5, 2022, the IRS issued a revised draft of the instructions for Schedules K-2 and K-3, and those revised draft instructions make changes to the criteria for the domestic filing exception. Since these instructions are still in draft form, further changes are possible.

The December 5 version of the draft instructions removes the specific due date for an entity to send certain required notices to its owners, and the new draft instructions revise the rule for when owners must respond to those notices. First, regarding the notices sent to owners, the new draft version still allows a separate notice to be sent to owners, but it now allows an entity to send the required notices along with the 2022 version of Schedules K-1 sent to the owners. Second, owners then have until 1-month before the date on which the entity actually files its 2022 return to respond to those notices. (If the entity files for an extension, the 1-month date could be as late as August 15, if the entity actually files its 2022 return on September 15.)

The date on which an entity files its 2022 return becomes an important measurement date under these new draft rules, and an entity has control over this date.

As a practical matter, when applying this new approach contained in the updated draft of the instructions, it appears that an entity otherwise eligible for the domestic filing exception can use the new rules to avoid giving its owners time to respond to the notices prior to the date on which it files its 2022 entity return. For example, an entity that is otherwise eligible for the domestic filing exception can prepare its 2022 return without including Schedules K-2 and K-3. It can then file its 2022 return with the IRS. At the same time, it can send the required notice to its owners with the 2022 Schedules K-1 for each of those owners. Since the entity has already filed it 2022 return, no owner will be able to respond to the notice within the 1-month period before the return is filed.

The new draft instructions also indicate that, if an entity receives a request from an owner to provide the Schedule K-3 to that owner, but the request occurs less than 1-month before the entity actually files its return (or occurs after the entity filed its return), the entity must send that information to the owner for the 2022 tax year within 30 days of the request. However, the entity is not required to send the 2022 Schedule K-3 to the IRS for the 2022 tax year. Once an owner makes such a request, in future years, the entity must send the Schedule K-3 to the owner and include it with the entity’s tax return filed with the IRS for tax years after 2022.

Separately, the December 5, 2022 draft instructions also limit the use of the domestic filing exception for partnerships and LLCs that are themselves owned by an S corporation or by another partnership or LLC. The exception does not apply to any partnership or LLC with a partnership owner. It also does not apply to a partnership or LLC that is owned by an S corporation with two or more shareholders or owned by an LLC with two or more members. An S corporation owner cannot have more than one shareholder itself, and an LLC owner must be a single-member disregarded entity. In each case the single shareholder or member must also be a US citizen or resident.

Reminder: It is possible that the IRS will make further revisions to the draft rules.

Entities and practitioners need to continue to carefully plan and assess how to address the filing requirement for Schedules K-2 and K-3.

If you have not yet attended, we will discuss this filing requirement and provide practical details and in-depth guidance in our upcoming seminars in December and January. If you are not already registered, register here.

January 4, 2023 Update: The final instructions for Schedules K-2 and K-3 match the December 5, 2022 draft version of the instructions.