What Are Schedules K-2 and K-3 for Tax Reporting?

The Internal Revenue Service (IRS) introduced Schedules K-2 and K-3 to standardize how pass-through entities report items with international tax implications. These forms are for owners of partnerships and S corporations, providing the details needed to calculate foreign-related tax obligations. They create a consistent format for information that was previously reported in various statements and attachments. The Tax Cuts and Jobs Act (TCJA) increased the complexity of determining U.S. tax liability on international items, and these schedules were developed to provide clearer reporting.

Defining Schedules K-2 and K-3

Schedule K-2, “Partners’ Distributive Share Items—International,” is an entity-level tax form filed by a pass-through business. It is an extension of the main Schedule K on the entity’s tax return and aggregates all income, deductions, and credits with international relevance. This schedule is not filed on its own but is attached to the primary income tax return of the business, such as Form 1065 for partnerships or Form 1120-S for S corporations.

From the data on Schedule K-2, the entity prepares a separate Schedule K-3 for each of its owners. Schedule K-3, “Partner’s Share of Income, Deductions, Credits, etc.—International,” breaks down the totals from the K-2 and reports each partner’s or shareholder’s specific share of those international items. An individual taxpayer who is a partner or shareholder receives a Schedule K-3, which serves as a detailed supplement to the more familiar Schedule K-1.

Entities with no direct foreign operations, foreign-source income, or foreign taxes paid may still be required to file these schedules. This is because the information may be necessary for the partners or shareholders to complete their own tax returns, particularly for calculating the foreign tax credit. Failure to file required schedules can lead to penalties that apply to incomplete Form 1065 or Form 1120-S filings.

Key Information Reported on the Schedules

Schedules K-2 and K-3 are extensive documents, but for most individual taxpayers, only a few parts are relevant. The most common sections an owner of a pass-through entity will encounter are Part II and Part III, which provide the necessary details for calculating the foreign tax credit. These parts are designed to give a clear picture of the international components of the entity’s activities.

Part II of the schedule, “Foreign Tax Credit Limitation,” provides a detailed breakdown of the entity’s gross income by source country. It will list income sourced from specific foreign countries, each identified by a two-letter country code, as well as income sourced from the United States. This information is needed for the recipient, as the foreign tax credit is calculated on a country-by-country basis.

Part III, “Other Information for Preparation of Form 1116 or 1118,” provides further details needed for the foreign tax credit calculation. Section 2 of this part reports information a partner needs to apportion their interest expense for the foreign tax credit limitation. Section 4 details the foreign taxes the entity paid or accrued, broken down by category of income and source country, which shows the taxpayer’s share of foreign taxes that may be eligible for a credit.

Other sections of the schedules address more specialized situations, such as reporting information related to investments in foreign corporations like Controlled Foreign Corporations (CFCs) or Passive Foreign Investment Companies (PFICs). This information is for those with more complex international holdings through the partnership or S corporation.

Using Schedule K-3 for Your Individual Tax Return

Upon receiving a Schedule K-3, the relevant information must be transferred to your individual tax return, Form 1040. The data on Schedule K-3 is not reported directly on the main pages of Form 1040. Instead, it is used to complete other forms that attach to your return, most commonly Form 1116, Foreign Tax Credit.

The information from Part II of your Schedule K-3, which details foreign source gross income, is entered into Part I of Form 1116. You will use the country-specific income figures from the K-3 to report your gross income from sources outside the United States. Form 1116 requires you to complete a separate form for each category of foreign income, and the K-3 provides this breakdown.

Next, you will use the data from Part III of the Schedule K-3 to complete other sections of Form 1116. For example, information regarding your share of the entity’s interest expense or other deductions is used to calculate your net foreign source income on Form 1116. The foreign taxes paid or accrued, also found in Part III, are reported in Part II of Form 1116.

The partnership or S corporation has already performed some of the necessary allocations and apportionments for you. Your task is to accurately transcribe this pre-calculated information onto the correct lines of Form 1116 to determine the amount of any foreign tax credit you are eligible to claim.

The Domestic Filing Exception

Some domestic partnerships and S corporations may not need to file Schedules K-2 and K-3 due to IRS exceptions for businesses with minimal international exposure. Beginning with the 2024 tax year, an exception is available for smaller entities with less than $250,000 in total receipts and less than $250,000 in total assets at the end of the tax year. If the entity you invest in qualifies, you will not receive a Schedule K-3 unless you request one.

For entities that do not meet the small entity criteria, the IRS provides a broader “domestic filing exception” if other conditions are met. First, the entity must have no or limited foreign activity. This is defined as having no foreign income taxes paid or accrued, or if there is foreign activity, it is limited to passive income that generates $300 or less in foreign taxes eligible for a credit.

A second condition is that all direct partners or shareholders must be U.S. citizens, resident aliens, certain domestic estates, or specific types of domestic trusts. This has been expanded to also include certain domestic partnerships and S corporations as qualifying partners.

Finally, the entity must notify its partners or shareholders that it qualifies for the exception and will not be providing a Schedule K-3 unless one is requested. This notification must be provided to the partner no later than when the Schedule K-1 is furnished. If a partner requests a K-3 by the deadline, which is one month before the entity files its tax return, the entity loses the exception and must provide the form to that partner.