03/16/2023

2022 Schedule K-2 and K-3 Filing Requirements Related to Pass-through Entities

It's vital to understand how this may impact shareholders, partners in business

Effective for tax year 2021, the Internal Revenue Service (IRS) introduced K-2 and K-3 Schedules as part of Form 1065 (U.S. Return of Partnership Income) and Form 1120S (U.S. Income Tax Return for an S Corporation) to make federal income tax liability more transparent for partners who share ownership in certain pass-through entities. Prior to the release of K-2 and K-3 Schedules, many partners and shareholders lacked an accurate understanding of their tax obligations. As a result, they found it difficult to determine their individual filing requirements, available foreign tax credits and if any additional taxes were owed in the U.S.

The initial K-2 and K-3 partnership instructions (applied for tax year 2021) provided a limited Domestic Filing Exception (DFE), with additional exceptions and guidance released on February 16, 2022 (FAQ 15). What came as a surprise to many taxpayers was the requirement to file Schedules K-2 and K-3 even if they had no foreign activity. The K-2 and K-3 is now mandatory for all Partnerships and S Corporations unless you can qualify for exemption under the DFE.

On Dec. 23, 2022, after several drafts, the IRS finalized the Partnership and S Corporation instructions for Schedules K-2 and K-3 for tax year 2022 with updated DFE. The DFE provides an exception to filing for solely domestic entities. The purpose is to identify businesses that do not need to include these new schedules on their tax returns because their owners do not have a need for the information on their personal returns.

Please select this link to read the complete article from OSAP Strategic Partner Clark Schaefer Hackett.