The IRS recently released 2022 tax year draft instructions for the Schedules K-2 and K-3 for Forms 1065, 8865 and 1120-S. The draft instructions update and modify with the 2021 versions in various ways in response to stakeholder comments, including expanding the domestic filing exception and offering a new country code when sourcing is determined by the partner. Although the instructions are not final, taxpayers may want to begin preparing correspondence with their investors on some key reporting issues.
Domestic filing exception
The most notable addition is a new domestic filing exception for filing and furnishing Schedules K-2 and K-3 for tax years beginning in 2022. The new exception expands the special relief provided in the prior year by FAQ #15 included in Schedules K-2 and K-3 Frequently Asked Questions (Forms 1065, 1120S, and 8865).
The exception for domestic partnership created in 2021 is limited to situations in which all the direct partners are either U.S. citizens (i.e., individuals, certain estates, trusts) or resident aliens. This meant if any of the partners are other partnerships, S corporations, C corporations, or foreign, then the partnership is not eligible for the exception. [Note that S corporations already have a similar limitation on investors to have an S election and thus do not have the specific requirement for their domestic filing exception.] For 2021, the partnership could not have any foreign activity.
The new draft instructions expand the exception to allow for certain “limited foreign activity.” Specifically, a domestic partnership must meet all of the following four criteria:
- During a domestic partnership’s tax year, it must either have “no foreign activity” or “limited foreign activity” (as defined in the instructions)
- During a domestic partnership’s tax year, all direct partners must be U.S. citizens/resident aliens
- The partnership must notify the partners that it does not intend to provide the schedules for no later than two months before the due date (without extension)
- The partnership must not have received a Schedule K-3 request from a partner one month before the due date (without extension)
If a pass-through entity meets the domestic filing exception criteria, then it does not need to complete and file with the IRS the Schedule K-2 nor furnish the Schedule K-3 to the investors. However, the draft instructions provide a special instruction that if a pass-through entity receives a request from an investor after the one-month date described in criteria four above and has not received a request from any other investor for Schedule K-3 information on or before the one-month date, then the pass-through entity is required to provide a completed Schedule K-3 to the requesting investor on the later of the date on which the pass-through entity files their return or one month from the date on which the pass-through entity receives the request from the investor. In that limited circumstance, the draft instructions provide that the domestic filing exception is met and the pass-through entity is not required to file the Schedules K-2 and K-3 with the IRS or furnish Schedule K-3 to the non-requesting investor. Note that this may require the investor to file a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR).
New county code available
Like prior years, the IRS has provided instructions specifically excluding the use of the country code “OC” when providing the country breakout for sourcing separate categories of income, thus continuing to require a detailed breakout by country code. For 2021, the instructions did not provide clear guidance on how to report country codes where the source of an item of gross income or gain (or a corresponding deduction) was determined by the partner. To address this issue, the draft instructions added “XX” as a country code when the partnership cannot determine the country or U.S. possession with respect to which the gross income and gross receipts are sourced because the source is determined by the partner.
The draft instructions included dozens of other updates, mostly focused on clarifying various reporting requirements related to the schedules. The instructions are still in draft form, so further monitoring is needed for any updates.
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