The IRS issued the final 2022 instructions for Schedules K-2 and K-3 for Form 1120-S on December 20, 2022.[1] The document contains the final instructions for a corporation to meet the domestic filing exception to preparing Schedules K-2 and K-3 for 2022. These rules are virtually the same as were found in the draft instructions released on December 5, 2022.

Domestic Filing Exception

The instructions begin by describing the domestic filing exception broadly:

An S corporation does not need to (i) complete and file with the IRS the Schedules K-2 and K-3, or (ii) furnish to a shareholder the Schedule K-3 (except where requested by a shareholder after the 1-month date (defined in criterion 3)) if each of the following are met with respect to the S corporation’s tax year 2022.[2]

The initial hurdle an S corporation must clear to be eligible to use the domestic filing exception is the “No or limited foreign activity” test. The test is defined as follows:

1. No or limited foreign activity. During an S corporation’s tax year 2022, the S corporation either has no foreign activity (as defined later), or if it does have foreign activity, such foreign activity is limited to:

Passive category foreign income (determined without regard to the high-taxed income exception under section 904(d)(2)(B) (iii)),
Upon which not 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
Such income and taxes are shown on a payee statement (as defined in section 6724(d)(2)) that is furnished or treated as furnished to the S corporation.[3]

For these purposes, foreign activity is defined as follows:

Foreign activity. For purposes of the Domestic Filing Exception, foreign activity means any of the following.

Foreign income taxes paid or accrued (as defined in section 901 and the regulations thereunder).
Foreign source income or loss (as determined in sections 861 through 865, and section 904(h), and the regulations thereunder).
Ownership interest in a foreign partnership (as defined in sections 7701(a)(2) and (5)).
Ownership interest in a foreign corporation (as defined in sections 7701(a)(3) and (5)).
Ownership of a foreign branch (as defined in Regulations section 1.904-4(f)(3)(vii)).
Ownership interest in a foreign entity that is treated as disregarded as an entity separate from its owner (as defined in Regulations section 301.7701-3).[4]

An entity that passes the foreign activity test must provide notifications to its shareholders that the corporation does not plan to provide the shareholders with Schedule K-3:

2. Shareholder notification. With respect to an S corporation that satisfies criterion 1, shareholders receive a notification from the S corporation at the latest when the S corporation furnishes the Schedule K-1 to the shareholder. The notice can be provided as an attachment to the Schedule K-1. The notification must state that shareholders will not receive Schedule K-3 from the S corporation unless the shareholders request the schedule.[5]

The final instructions retain the provision that allows the corporation to provide this notice with the K-1s sent to the shareholders at the time the return is filed.

The final hurdle to clear for the corporation to not be required to provide Schedules K-2 and K-3 with its 2022 Form 1120-S filing with the IRS requires that the entity not receive any Schedule K-3 requests by a date one month before the date the entity files its Form 1120-S for 2022:

3. No 2022 Schedule K-3 requests by the 1-month date. The S corporation does not receive a request from any shareholder for Schedule K-3 information on or before the 1-month date. The “1-month date” is 1 month before the date the S corporation files the Form 1120-S. For tax year 2022 calendar year S corporations, the latest 1-month date is August 15, 2023, if the S corporation files an extension.[6]

A key item to note here is that, unlike the original draft instructions issued in October, there is no provision requiring the notice to the shareholders to be issued prior to the 1-month date. In fact, given that the instructions specifically point out that the notice can be sent as part of the Schedule K-1 package to shareholders, the IRS has authorized providing the notice well after the 1-month date will have passed.

Although there will be no filing of this information with the IRS if there is no request by the 1-month date, if a shareholder sends in a request for Schedule K-3 after the 1-month date the corporation still must take action to provide the shareholder that information:

Note. If an S corporation receives a request from a shareholder for the Schedule K-3 information after the 1-month date and has not received a request from any other shareholder for Schedule K-3 information on or before the 1-month date, the Domestic Filing Exception is met and the S corporation is not required to file the tax year 2022 Schedules K-2 and K-3 with the IRS or furnish the tax year 2022 Schedule K-3 to the non-requesting shareholders.

However, the S corporation is required to provide the tax year 2022 Schedule K-3, completed 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 1 month from the date on which the S corporation receives the request from the shareholder.[7]

Note that receiving this request related to the 2022 return will require the corporation to prepare Schedules K-2 and K-3 for the information requested by this shareholder for the 2023 Form 1120-S filing with the IRS:

The S corporation must complete and file tax year 2023 Schedules K-2 and K-3 with respect to the requesting shareholder by the tax year 2023 Form 1120-S filing deadline.[8]

Rule for Corporations That Receive at Least One Request for Schedule K-3 by the 1-Month Date

The instructions provide guidance for an S corporation that meets the first two requirements, but receives a request for a Schedule K-1 from at least one shareholder by the 1-month date that will limit the information required to be provided to the IRS by the corporation:

If the S corporation received a request from a shareholder for Schedule K-3 information on or before the 1-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.

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, if 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 the S corporation’s 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 that the S corporation files Schedules K-2 and K-3 with the IRS, the S corporation must provide a copy of the filed Schedule 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 Schedules 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.[9]

Guidance is also provided for the case where shareholder requests for a Schedule K-3 are received both before and after the 1-month date:

If an S corporation receives requests from shareholders for Schedule K-3 information both on or before the 1-month date and after the 1-month date, the S corporation is required to 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 1-month date. With respect to requests received after the 1-month date, the S corporation is required to provide the Schedule 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 1 month from the date on which the S corporation receives the request from the shareholder.[10]

Form 1116 Exception

The final instructions also continue to provide a separate Form 1116 exemption that may be available to corporations that are unable to meet the Domestic Filing Exception:

Note. If an S corporation does not meet the Domestic Filing Exception, it may meet the Form 1116 Exemption to filing the Schedules K-2 and K-3. See Form 1116 Exemption, later.[11]

In this case, the corporation looks to obtain statements from the shareholders that they are not required to file Form 1116 to claim a foreign tax credit:

Under section 904(j), certain shareholders are not required to file a Form 1116 (“Form 1116 Exemption”). Also see Foreign Tax Credit - How to Figure the Credit on IRS.gov. An S corporation is not required to complete Schedules K-2 and K-3 if all shareholders are eligible for the Form 1116 Exemption and the S corporation receives notification of the shareholders’ eligibility for such exemption by the 1-month date (as defined earlier).[12]

If the corporation obtains this notification from some, but not all shareholders, the instructions provide that Schedules K-3 only need to be provided to those shareholders who failed to provide the notification:

If an S corporation receives notification from only some of the shareholders that they are eligible for the Form 1116 Exemption, the S corporation need not complete the Schedule K-3 for those exempt shareholders but must complete the Schedules K-2 and K-3 with respect to the other shareholders to the extent that the S corporation does not qualify for the Domestic Filing Exception.[13]

Consider the Option to Just Prepare the Forms

Advisers may wish to consider the other alternative to qualifying the S corporation to meet either the Domestic Filing Exception or the Form 1116 Exemption Exception—just preparing the Schedules K-2 and K-3 for an S corporation with only domestic activities.

Several professional tax software publishers have added the option to check a box that tells the software that the entity has only United States operations. When the box is checked the software uses the information entered on the forms to complete the rest of the Form 1120-S to populate Parts II and III of Schedules K-2 and K-3 based on the normal allocation information for profits and losses for the return, as well as the average book value for assets reported on the corporation’s depreciation schedule.

For many simple S corporations, this procedure will produce either a correct Schedule K-2 and K-3, or a starting point for quickly creating proper Schedules K-2 and K-3 for the corporation. In that case, taking the additional steps to meet the requirements to meet either exceptions may consume far more professional time than simply preparing these forms for filing with the Form 1120-S and providing the appropriate Schedule K-3 to each shareholder.

[1] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, https://www.irs.gov/pub/irs-pdf/i1120s23.pdf (retrieved December 21, 2022)

[2] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[3] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[4] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[5] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p.3

[6] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p.3

[7] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[8] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[9] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[10] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 3

[11] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 4

[12] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 9

[13] 2022 S Corporation Instructions for Schedules K-2 and K-3 (Form 1120-S), December 20, 2022, p. 9