Schedule K-3 Filing Requirements for Form 1065

Form 1065, the U.S. Return of Partnership Income, is the informational return filed annually by domestic partnerships to report their financial activities to the IRS. This form details the partnership’s income, gains, losses, deductions, and credits. From this return, the partnership issues a Schedule K-1 to each partner, outlining their individual share of the partnership’s financial results.

The IRS introduced Schedules K-2 and K-3 to standardize the reporting of items with international tax relevance. Schedule K-2 is an extension of Form 1065 reporting the partnership’s total international tax items. Schedule K-3 breaks down that information and is provided to each partner, giving them the data needed to complete their own tax returns regarding matters like the foreign tax credit.

The Filing Requirement for Schedules K-2 and K-3

A partnership is required to file Schedules K-2 and K-3 if it has any items of international tax relevance. This includes activities such as having foreign source income, paying foreign taxes, or holding ownership in foreign entities. To reduce the compliance burden on domestic businesses, the IRS established two exceptions.

The first is the domestic filing exception. A partnership that meets all four of the following criteria is not required to file Schedules K-2 and K-3 with the IRS or furnish Schedule K-3 to its partners, unless a partner requests one.

• The partnership has no or limited foreign activity. This includes paying or accruing foreign income taxes, generating foreign source income, or holding an ownership interest in a foreign entity. A small amount of passive foreign income is allowed if the partnership paid no more than $300 in creditable foreign taxes and received this information on a standard payee statement.
• All direct partners throughout the tax year are U.S. citizens, resident aliens, domestic decedent’s estates with only U.S. citizen or resident alien beneficiaries, certain domestic trusts with only U.S. citizen or resident alien grantors and beneficiaries, S corporations, or single-member LLCs whose sole member is one of the other qualifying persons.
• The partnership notifies its partners that they will not receive a Schedule K-3 unless they request it. This notice must be provided no later than when the partnership furnishes the annual Schedule K-1.
• No partner requests a Schedule K-3 by the “1-month date,” which is one month before the partnership files its Form 1065. If a partner submits a request by this deadline, the partnership fails to meet the exception and must file the completed schedules.

If a partnership meets the domestic filing exception and a partner requests a Schedule K-3 after the 1-month date, the partnership is not required to file Schedules K-2 and K-3 with the IRS. It must only furnish the Schedule K-3 to the requesting partner with the parts relevant to that partner’s request completed. The second exception is for small partnerships with less than $250,000 in total assets at year-end and less than $250,000 in total receipts during the tax year.

Information Reported on Schedule K-3

Schedule K-3 is a multi-part form that provides a partner with a detailed breakdown of their share of the partnership’s international tax items. It translates the partnership’s total international amounts from Schedule K-2 into each partner’s distributive share.

Part I of the schedule identifies the partner and the partnership. It also contains a checkbox for the partnership to indicate which subsequent parts of the form have been completed, guiding the partner to the relevant sections.

Parts II and III relate to the foreign tax credit. Part II, “Foreign Tax Credit Limitation,” provides the partner’s share of gross income from various foreign country sources and across different income categories. Part III, “Other Information for Preparation of Form 1116 or 1118,” provides a partner’s share of deductions, losses, and foreign taxes paid or accrued. This section details the specific amount of foreign taxes passed through to the partner and the foreign country to which the taxes were paid.

Other parts of Schedule K-3 report more specialized international tax information. For instance, Part IV contains information related to the Foreign-Derived Intangible Income (FDII) deduction. Part V reports a partner’s share of distributions from foreign corporations. Subsequent parts can provide data on controlled foreign corporations (CFCs), such as Subpart F income or Global Intangible Low-Taxed Income (GILTI).

How a Partner Uses Schedule K-3 Information

Upon receiving a Schedule K-3, a partner transfers the information to their own income tax return. The form is not filed by the partner but serves as a source document.

The most common use of Schedule K-3 is to complete Form 1116, which is used by individuals, estates, and trusts to claim the foreign tax credit. The credit is designed to mitigate the double taxation of income that is taxed by both a foreign country and the United States. To properly calculate the credit, a taxpayer must determine their foreign source taxable income, which requires a detailed allocation of income and deductions.

The data from Schedule K-3 directly populates Form 1116. The foreign source gross income reported in Part II of Schedule K-3 is used to complete Part I of Form 1116. The various income categories on the K-3, such as passive or general, correspond to the separate Form 1116 that must be filed for each category.

Similarly, the allocable deductions from Part III of the K-3 are entered on Form 1116 to arrive at the net foreign source income figure. The foreign taxes paid or accrued, as detailed in Part III of Schedule K-3, are reported in Part II of Form 1116. Without the detailed breakdown from Schedule K-3, a partner would find it difficult to substantiate a claim for a foreign tax credit.