December 19, 2022
Draft instructions for 2022 partnership Schedules K-2 and K-3 incorporate previous guidance, include new domestic filing exception
In the latest draft 2022 Partnership Instructions for Schedules K-2 and K-3 (Form 1065), released on December 2, 2022, the IRS incorporated most of the relief provided in previous FAQs and "Changes to the 2021 Partnership Instructions for Schedules K-2 and K-3 (Form 1065)" (issued January 18, 2022) (see Tax Alert 2022-0152). In addition, the draft instructions include a new filing exception for domestic partnerships that meet certain requirements.
Domestic filing exception
According to the instructions, a domestic partnership does not need to complete and file Schedules K-2 and K-3 with the IRS, or furnish Schedules K-3 to partners, if it meets the following four criteria in its 2022 tax year:
These criteria differ from those in IRS FAQ 15 (issued February 16, 2022), which provided an exception for filing Schedules K-2 and K-3 for certain domestic partnerships and S corporations in the 2021 tax year. The draft instructions extend this exception to partnerships with "limited foreign activity," which means:
The major difference from the 2021 exception is that the draft instructions exclude domestic partnerships and corporations from the acceptable types of direct partners that can qualify for the exception. To qualify for the exception, domestic partnerships can only have direct partners of the following types:
The draft instructions also specify how the partnership and partners must communicate in order for the exception to apply. A partnership must tell the partners that the partnership will not prepare Schedule K-3 either on or before the date that the partnership issues the Schedule K-1 (this notice can be attached to the K-1).
Partners must notify the partnership if they need a Schedule K-3. If the partnership receives this notice more than one month before filing its Form 1065, then the partnership does not meet the domestic filing exception and must file Schedules K-2 and K-3 with the IRS and provide Schedule K-3 to every partner. If the partnership receives the notice after the one-month date, then the partnership meets the domestic filing exception and does not need to file Schedules K-2 and K-3 with the IRS. The partnership will, however, need to provide the requesting partner with a Schedule K-3 with the information relevant to that partner on the later of (1) the date on which the partnership files the Form 1065, or (2) one month from the date on which the partnership receives the request from the partner.
Once the partnership is notified that a partner needs a Schedule K-3 for tax year 2022, the partnership will not meet the domestic filing exception for tax year 2023 and must file Schedules K-2 and K-3 for all partners with the IRS.
To help manage partner expectations, partnerships should consider communicating with partners early if they do not intend to issue Schedules K-3 and ask their partners to respond within a specified time frame if a partner needs a Schedule K-3.
Clarified reporting requirements
The IRS revised and clarified several sections in the draft instructions.
Part I — Box 1 (Table 1)
A partnership is only required to report gains and is no longer required to report proceeds and basis. If the gain is capital, the partnership must enter "long-term" or "short-term" in the designated column of Table 1. For sales of stock, a partnership may now combine the sales by country, but non-stock sales must still be listed separately.
Parts II and III
A partnership must complete Parts II and III unless (1) it does not have a direct or indirect partner that is eligible to claim a foreign tax credit, or (2) no direct or indirect partner would have to file a Form 1116 or Form 1118. A domestic partnership is not required to complete Schedules K-2 and K-3 if all partners are eligible for the Form 1116 exemption and the partnership receives notification of the partners' eligibility for that exemption by the one-month date. This requirement could be challenging because the notification must come from the exemption-eligible partners, who are less likely to need a Schedule K-3. This requirement differs from the domestic filing exception, which requires partners to alert the partnership that they need a Schedule K-3.
For Part II, column (f), a partnership can select new code "XX" when it cannot determine the source because the source is determined by the partner's residence. This code cannot be used when the partnership cannot obtain sourcing detail.
Capital gains and losses
The draft instructions caution partnerships against double counting certain capital gains and losses in Part II and Part X, which could overstate foreign-source income on Forms 1116 and 1118 and effectively connected income on Schedule P (Form 1120-F).
Research and experimental expense (R&E) apportionment
A partnership should complete the R&E items when it incurs R&E expenses or expects the partner to license, sell or transfer its intangible property to the partnership. This pertains to Part III, Sec 1; Part IV, Sec 3, lines 15 and 16; and Part X, Sec 3, line 5 for the apportionment factors.
Interest expense and stewardship expense apportionment
The draft instructions clarify how to report information on Part II, Section 2, and Part III, Section 2, and now cover stewardship expenses.
Part III — Sections 3 and 4
Partnerships with no direct or indirect domestic corporate partners are not required to complete Section 3. Partnerships that do not pay or accrue foreign taxes are not required to complete Section 4.
A new exception from IRC Section 863(b) reporting of taxes by country applies for regulated investment companies.
For partnerships contesting a foreign income tax liability with a foreign country, a new reporting requirement applies. Partnerships that have remitted all or a portion of the contested liability should report information about the contested tax on Line 3 of Section 4, along with a statement containing enough information for a partner to complete Form 7204, Consent To Extend the Time To Assess Tax Related to Contested Foreign Income Taxes — Provisional Foreign Tax Credit Agreement, and Schedule L (Form 1118) and/or Schedule C (Form 1116), depending on the partner's US tax classification.
For Section 1, Line 1, the draft instructions clarify that net income (loss) may equal line 1 of Analysis of Net Income (Loss) on page 5 of Form 1065. For Section 3, Line 13, they clarify that interest expense includes excess business interest expense determined under IRC Section 163(j)(4).
The draft instructions clarify that their references to mark-to-market (MTM) elections for passive foreign investment companies (PFICs) generally refer to elections under IRC Section 1296 and not to any other section of the Code or regulations. This section of the instructions also gives guidance on how to report information for existing PFICs with an IRC Section 1296 election made in current tax year.
The instructions do not require a domestic partnership to complete Schedule K-2 and K-3, Part VII for passive foreign investment company (PFIC) stock that is a non-initial IRC Section 1296 MTM election unless the foreign corporation may be treated as a qualifying insurance corporation that is treated as a PFIC under IRC Section 1298(b)(1).
The draft instructions clarify that a domestic partnership is not required to complete Schedule K-3, Part X, if it does not have any effectively connected income and the partnership or another withholding agent has met its withholding and reporting obligations. A foreign partnership is not required to complete Schedule K-3, Part X, if (1) the foreign partnership does not have a domestic pass-through partner with a direct or indirect foreign owner, and (2) the partnership files a partnership return under Treas. Reg. Section 1.6031(a)-1(b)(3)(iii) (foreign partnerships with US-source income and US partners).
New reporting requirements
The IRS has added new reporting requirements for the following sections:
Penalties not addressed
The draft instructions do not cover penalties. Taxpayers should refer to the penalties section of the instructions to Form 1065 and the Code and regulations. The transitional penalty relief provided in Notice 2021-39 is not expected to apply for tax year 2022.
The new instructions offer more clarity on partnership reporting obligations. Several examples added to the draft instructions suggest the IRS wants partnerships to be more transparent, particularly those with corporate partners.
The domestic filing exception is generally more restrictive than the prior filing exception, as a partnership with partnership or corporate partners does not qualify. Taxpayers that relied on the exception to refrain from filing in tax year 2021 should consider taking a fresh look at the updated exception for tax year 2022.
Partnerships considering taking advantage of the domestic filing exception should consider revisiting their communication plans with partners in order to receive notice from partners who need Schedules K-3 in time. While the IRS has not mandated any dates except the "one month date," it may take the partnership longer than one month to prepare Schedules K-3 for all partners if necessary.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor