Desktop: Form 1065 - Schedule K-2 and Schedule K-3

Due to the complexity of the reporting requirements of Schedules K-2 and K-3, it is essential that you familiarize yourself with the IRS instructions relevant to the parts of the form you are completing. Don't attempt to complete these schedules without having read the IRS instructions (linked at the bottom of this article).

Who needs to complete Schedules K-2 and K-3?

Schedules K-2 and K-3 are used by a partnership to report items relevant to the international provisions of the tax code. Thus, a partnership return may need to include Schedules K-2 and K-3 if items such as these are present in the return:

• Partnership investment in a foreign entity.
• Income distributed from a foreign corporation.
• Information relevant to the foreign tax credit, such as foreign income or deductions.
• A foreign partner's US source income or effectively connected income.
• Foreign intangible income.
• Investment in a controlled foreign corporation (CFC).
• Investment in a passive foreign investment company (PFIC).
• Subpart F income.
• Global intangible low-taxed income (GILTI).

Who doesn't need to complete Schedules K-2 and K-3?

A domestic partnership (in other words, an unincorporated organization created in the United States or under US or state law with more than one member that is not an estate or trust) doesn't need to complete Schedules K-2 and K-3 if during the tax year all four of these criteria are true:

1. The partnership has no or limited foreign activity. The term "foreign activity" encompasses any of the following:
   1. foreign source income or loss;
   2. foreign taxes paid or accrued;
   3. ownership interest in a foreign partnership;
   4. ownership interest in a foreign corporation;
   5. ownership of a foreign branch;
   6. ownership in a disregarded entity.
   The partnership's foreign activity is limited to:
   1. passive category income (determined without regard to the high-taxed income exception), upon which
   2. $300 or less of foreign income taxes were paid or accrued (and for which the foreign tax credit would be allowed), and
   3. such income and taxes are shown on a payee statement furnished to the partnership.
2. All the partners are US citizens or resident aliens. All the direct partners fit into any of these categories:
   1. US citizen;
   2. resident alien;
   3. domestic decedent estate with only US citizen or resident alien individual beneficiaries;
   4. domestic grantor trust with only US citizen or resident alien individual grantors and only US citizen or resident alien individual beneficiaries;
   5. domestic non-grantor trust with only US citizen or resident alien individual beneficiaries;
   6. S corporation with a single shareholder;
   7. single-member LLC where the LLC is disregarded as an entity separate from its owner and the owner fits one of category a through f above.
3. Partners have been notified that Schedule K-3 won't be provided. For a partnership that meets criteria 1 and 2 above, the partners have been notified that Schedule K-3 won't be provided to them unless the partner requests it. (Notification can be done as an attachment to Schedule K-1 or separately).
4. No partner requests the Schedule K-3 by "the 1-month date". The 1-month date is one month before the date the partnership files Form 1065. If Schedules K-2 and K-3 aren't otherwise required to be filed according to criteria 1, 2, and 3, and no partner requests Schedule K-3, the partnership doesn't need to complete it.
   
   But, if a partner requests Schedule K-3 within the 1-month date, the partnership must complete Schedule K-2 and provide Schedule K-3 to the partner who requested it. Only the items relevant to the partner need to be reported on the schedule.

When were Schedules K-2 and K-3 introduced?

Schedule K-2 is an extension of Schedule K (Form 1065) and was introduced in tax year 2021. Compared to Schedule K prior to 2021, Schedule K-2 replaced lines 16a to 16r, portions of line 20, and many statements that were attached to Schedule K.

Similarly, Schedule K-3 is an extension of Schedule K-1 and reports a partner’s distributive share of the items in Schedule K-2.

Completing Schedules K-2 and K-3 in TaxSlayer Pro

Before completing Schedule K-2, first ensure it needs to be completed. If it needs to be completed or you and/or the partners wish it to be completed, the details for how to complete each part are in the IRS Schedule K-2 instructions and should be referred to.

Secondly, determine which parts need completion based on the partnership's foreign activity. (See below for a brief overview of the different parts.)

To complete Schedule K-2 in the partnership return in TaxSlayer Pro, from the Main Menu of Form 1065 select:

• Schedule K - Distributive Share Items
• Foreign Transactions (K-2)

In brief, the steps to complete Schedules K-2 and K-3 are as follows:

• Select Heading Information and answer Yes or No to the two questions regarding whether or not the partnership is a withholding foreign partnership or a qualified derivatives dealer.
• Complete the remaining parts that need completion.

Summary of the Schedules K-2 and K-3 parts

Part I - Partner’s Share of Partnership’s Other Current Year International Information

Part I consists of several check boxes and reports items not reported in any other part. If an item applies, check its check box, then read the Schedule K-2 instructions for how to report the information to the partners.

Part II - Foreign Tax Credit Limitation

Part II is used to figure the partnership’s income or loss by source and separate category of income and to report the partner’s distributive share of the income or loss. Partners will use this information to figure and claim a foreign tax credit on Form 1116 or 1118.

Part II consists of two sections to be completed as needed:

• Section 1 - Gross Income
• Section 2 - Deductions

Part III - Other Information for Preparation of Form 1116 or 1118

Part III reports information necessary for the partner to determine the allocation and apportionment of research and experimental (R&E) expense, interest expense, and the foreign-derived intangible income (FDII) deduction for the foreign tax credit limitation.

Part III consists of five sections to be completed as needed:

• Section 1 - R&E Expense Apportionment Factors - In general, R&E expenses are allocated and apportioned by the partner.
• Section 2 - Interest Expense Apportionment Factors - This section requires the partnership to report information that a partner will use to allocate and apportion its interest expense for foreign tax credit limitation purposes.
• Section 3 - Foreign-Derived Intangible Income (FDII) Deduction Apportionment Factors - This section requires the partnership to report information that a partner will use to allocate and apportion its FDII deduction under section 250(a)(1)(A) for foreign tax credit limitation purposes. 
• Section 4 - Foreign Taxes - The partnership assigns foreign taxes paid or accrued (including on U.S. source income) to a separate category and source. Include taxes paid or accrued to foreign countries or to U.S. possessions.
• Section 5 - Other Tax Information - Report the section 743(b) income adjustments allocated to the partnership by source, separate category, and class of gross income.

Part IV - Information on Partners’ Section 250 Deduction With Respect to Foreign-Derived Intangible Income (FDII)

Part IV provides Information to complete Form 8993, a form used by domestic corporations (and US
individual shareholders of CFCs making a section 962 election) to determine the allowable deduction under IRC section 250 related to foreign-derived intangible income and global intangible low-taxed income. See the Form 8993 instructions for more information.

Part V - Distributions From Foreign Corporations to Partnership

Part V is provides information regarding distributions by foreign corporations to the partnership. See here for more information about Part V.

Part VI - Information on Partners’ Section 951(a)(1) and Section 951A Inclusions

Part VI must be completed if the partnership owns stock in a CFC, unless the ownership is solely by reason of applying IRC section 318(a)(3) (providing for downward attribution) as provided in IRC section
958(b). Partners will use the information to complete Form 8992 and calculate their GILTI inclusion. See the Form 8992 instructions for more information.

Part VII - Information Regarding Passive Foreign Investment Companies (PFICs)

Part VII provides information about the partnership's ownership in a passive foreign investment company (PFIC). and partners will use this information to complete Form 8621.

Part VIII - Partnership’s Interest in Foreign Corporation Income (Section 960)

Part VIII is completed for

1. direct partners that are domestic corporation US shareholders or that may be eligible to make a section 962 election to claim a deemed paid foreign tax credit, and
2. direct partners who may have direct or indirect partners who may be eligible to claim the indirect credit.

Note that amounts in Part VIII are reported in foreign currency.

Part IX - Partners’ Information for Base Erosion and Anti-Abuse Tax (Section 59A)

Part IX is provides information for a partner that is a large corporation and that will be filing Form 8991.

Part X - Foreign Partners’ Character and Source of Income and Deductions

Part X provides information that a foreign partner will use when filing their nonresident tax return, Form 1040-NR. However, Part X doesn't need to be completed if

1. the partnership doesn't have any effectively connected income (ECI), and
2. the partnership or another withholding agent has met its withholding and reporting obligations under chapters 3 and 4 with respect to its income.

Part XI - Foreign Partners’ Character and Source of Income and Deductions

Part XI must be completed if the partnership is a PTP that

1. is a covered partnership as defined in Regulations section 1.871-15(m)(1); or
2. directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership.

These two criteria apply regardless of whether the partners are domestic or foreign.

A partner that has entered into a section 871(m) transaction that references units in the partnership will use the information in this part to determine their U.S. withholding tax and reporting obligations with respect to those transactions under section 871(m) and related rules.

Additional Information:

IRS: Partnership Instructions for Schedules K-2 and K-3 (Form 1065)

Schedule K-2 and Schedule K-3 Part VII - Information to Complete Form 8621

Schedule K-2, Part V, and Schedule K-3, Part V (Distributions From Foreign Corporations to Partnership)

Form 1065- Schedule K-2 and Schedule K-3 Part IX - Partner’s Information for Base Erosion and Anti-Abuse Tax (Section 59A)