The Internal Revenue Service issued a draft set of instructions for an S corporation’s 2022 Schedule K-2s and K-3s last week in response to heavy demand from tax practitioners following the release of a draft set of instructions for a partnership’s 2022 Schedule K-2s and K-3s last month.
Tax professionals have been clamoring for more detail and clarity regarding whether (and under what circumstances) corporations and partnerships must file Schedules K-2 and K-3, particularly where they have little or no foreign activity and shareholders or partners. The IRS provides such clarification in these draft instructions.
Domestic filing exception for 1065 and 1120S returns
Similar to the 2022 instructions for partnerships, the IRS has expanded relief and clarity by adding a new “domestic filing exception” for S corporations’ draft instructions for the 2022 tax year schedules K-2 and K-3.
The domestic filing exception for S corporations is very similar to the one for partnerships. However, unlike the four criteria partnerships must meet, S corporations are required to meet three tests. The one requirement omitted relates to U.S. citizens and resident alien individuals, domestic trusts and estates; S corporations aren’t permitted to have the latter entities as shareholders.
What is the domestic filing exception for Schedules K-2 and K-3 in tax year 2022?
An S corporation doesn’t need to complete and file Schedules K-2 and K-3, or furnish a K-3 to a shareholder — except where requested by a shareholder after the one-month date (see criterion 3 below) — if each of the following is met for the S corporation’s tax year 2022.
1. No or limited foreign activity
During an S corporation’s tax year 2022, the S corp either has no foreign activity, or if it does have foreign activity, it is limited to:
- Passive category foreign income upon which no more than $300 of foreign income taxes allowable as a credit under section 901 are treated as paid or accrued by the S corporation, and
- Income and taxes are shown on a payee statement furnished or treated as furnished to the S corporation.
For purposes of defining the domestic filing exception, foreign activity means any of the following:
- Foreign income taxes paid or accrued;
- Foreign source income or loss;
- Ownership interest in a foreign partnership;
- Ownership interest in a foreign corporation;
- Ownership of a foreign branch; or
- Ownership interest in a foreign entity that is treated as disregarded as an entity separate from its owner.
2. Shareholder notifications for S corporations satisfying criterion one are provided
For an S corporation that satisfies criterion one, the shareholders must receive a notification from the S corporation either electronically or by mail dated no later than two months before the due date. This due date ignores any extensions that may have been filed, making the due date Jan. 15, 2023.
The notification must state that shareholders will not receive Schedule K-3 from the S corporation unless the shareholders request the schedule.
3. No 2022 Schedule K-3 requests by the one-month date
If an S corporation receives a request from a shareholder for the K-3 information after the one-month date and has not received a request from any other shareholder for K-3 information on or before the one-month date, the domestic filing exception is met, and the S corporation is not required to file the Schedules K-2 and K-3 with the IRS or furnish the K-3 to the non-requesting shareholders.
Note: The one-month date is one month before the due date (without extension) of the S corporation’s Form 1120-S. For calendar year S corporations, the one-month date is Feb. 15, 2023, for tax year 2022.
However, the S corporation is required to provide the K-3, complete with the requested information, to the requesting shareholder on the later of:
- The date on which the S corporation files the Form 1120-S; or
- One month from the date on which the S corporation receives the request from the shareholder.
See example 3 in the IRS draft instructions.
Note: For S corporations that satisfy criteria 1 and 2, but do not satisfy criterion 3, if the S corporation received a request from a shareholder for Schedule K-3 information on or before the one-month date and therefore the S corporation does not satisfy criterion 3, the S corporation is required to file the Schedules K-2 and K-3 with the IRS and furnish the Schedule K-3 to the requesting shareholder.
Additional insights from the draft instructions
The draft instructions note the Schedules K-2 and K-3 are required to be completed only with respect to the parts and sections relevant to the requesting shareholder.
For example, suppose a shareholder requests the information reported in Part III, Section 2 (interest expense apportionment factors). The S corporation is required to complete and file Schedule K-2, Part III, Section 2, with respect to its total assets and Schedule K-3, Part III, Section 2, with respect to the requesting shareholder’s pro rata share of the assets.
- On the date the S corporation files Schedules K-2 and K-3 with the IRS, it must provide a copy of the filed K-3 to the requesting shareholder.
- The S corporation does not need to complete, attach, file or furnish any other parts or sections of the K-2 and K-3 to the IRS, the requesting shareholder or any other shareholder.
- The S corporation should keep records of the information requested by the shareholder.
See example 2.
Suppose an S corporation receives requests from shareholders for K-3 information on or before the one-month date. In that case, the S corporation must file Schedules K-2 and K-3 as described in the prior paragraph only with respect to the shareholder requests received on or before the one-month date.
With respect to requests received after the one-month date, the S corporation is required to provide the K-3, completed with that shareholder’s requested information, on the later of the date on which the S corporation files the Form 1120-S or one month from the date on which the S corporation receives the request from the shareholder.
The draft instructions provide a number of examples to further clarify when and where not the domestic filing exception applies.
