The Essential Guide to Mastering Schedules K-2 and K-3: Key Rules and Strategies for 2025

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As international tax reporting becomes more complex, partnerships, S corporations, fund managers, and tax professionals must stay ahead of evolving regulations. Schedules K-2 and K-3 require detailed reporting of foreign income, taxes, and other international provisions, with significant implications for compliance. These schedules introduce new challenges for accurate and timely reporting. Let’s explore the essential aspects of Schedules K-2 and K-3 and how to effectively manage the reporting process.

Entities Required to File Schedules K-2 and K-3

Who Must File: 

• Domestic Partnerships: Any partnership required to file Form 1065 that has items relevant to the determination of U.S. tax or specific withholding tax or reporting obligations of its partners under the international provisions of the Internal Revenue Code must complete the relevant parts of Schedules K-2 and K-3.
• Foreign Partnerships: U.S. persons required to file Form 8865 for interests in foreign partnerships must also file Schedules K-2 and K-3 (Form 8865) if the partnership has items relevant to U.S. international tax.
• S Corporations: Any S corporation that is required to file Form 1120-S and that has items relevant to the determination of the U.S. tax or reporting obligations of its shareholders under the international provisions of the Internal Revenue Code (Code) must complete the relevant parts of Schedules K-2 and K-3.

Exceptions:

• Domestic Filing Exception:
  A domestic partnership or S corporation may be exempt from filing Schedules K-2 and K-3 if it meets all four of the following criteria:

  1. It has no or limited foreign activity.

  2. All direct partners are U.S. citizens/residents or certain domestic entities.

  3. The partners are notified that Schedule K-3 will not be provided unless requested.

  4. No partner requests Schedule K-3 by the “1-month date” (one month before the partnership files Form 1065).

When to File:

Schedules K-2 and K-3 are filed with the partnership or S corporation tax returns by their respective due dates (including extensions).

For more on international flow-through entity filing obligations, see this resource.

Purpose and Objectives of the New Schedules

Schedules K-2 and K-3 were implemented to standardize and expand the reporting of international tax information by partnerships and S corporations. The main objectives are:

• Transparency: Provide detailed, standardized information to partners and shareholders for their international tax compliance, including foreign tax credit calculations, GILTI, Subpart F, and other international provisions.
• Completeness: Ensure all items relevant to international tax are reported, including those not previously captured on Schedule K-1.
• Facilitation of IRS Review: Enable the IRS to more easily review and match partnership and partner-level international tax reporting.

Key Uses: 

• Calculating the foreign tax credit limitation (Form 1116/1118)
• Reporting Subpart F and GILTI inclusions for certain US Shareholders
• Reporting annual PFIC information, including PFIC distributions, QEF information, and MTM information
• Reporting distributions (including dividends) from foreign corporate investments
• Reporting US Effectively Connected Income and FDAP to foreign investors
• Providing data for BEAT, FDII, and other international provisions

Implications for Partnerships, S Corporations, and Fund Managers

1. Increased Reporting Burden & Compliance Costs for Flow-Through Entities

• The volume and complexity of required disclosures have grown dramatically. Schedules K-2 and K-3 can be 20+ pages each.
• Flow-through entities must collect, analyze, and report detailed information on foreign income, assets, taxes, and other relevant international provisions, which can result in higher costs of compliance and longer hours to comply.

2. Data and Systems Challenges

• Many flow-through entities, especially in the alternative investments industry, must upgrade systems and processes to capture the required data.
• Coordination with service providers and custodians is often necessary to obtain country-level and asset-level information.

3. Investor Demands and Ad Hoc Requests

• Investors increasingly request detailed tax information, including Schedules K-3, to support their own compliance and reporting needs.
• Partnerships must be prepared to respond to partner requests for K-3s, even if they qualify for the domestic filing exception.

4. Audit and Enforcement Risk

• The IRS has increased its focus on large partnerships and international tax compliance, using technology and data analytics to identify discrepancies and potential noncompliance.
• Incomplete or inaccurate Schedules K-2 and K-3 can trigger penalties and audits.

5. Legislative and Regulatory Uncertainty

• The international tax landscape continues to evolve, with ongoing changes to U.S. and global rules (e.g., BEPS, Pillar Two, GILTI, BEAT, FDII).
• Partnerships must monitor developments and adapt their reporting as new guidance is issued.

6. Penalties for Noncompliance for Flow-Through Entities

• Failure to file complete and accurate Schedules K-2 and K-3, or to furnish K-3s to partners as required, can result in significant penalties—$330 per failure per partner, up to $3,987,000 per year for large entities.

7. Penalties for Noncompliance for Investors Receiving Form K-3

• Failure for an investor to properly report information passed down on Form K-3 can result in significant penalties, as well. These include but are not limited to missing forms such as Form 8992, Form 8858, Form 926, or Form 8621, which can result in large monetary penalties, as well as leaving the Statue of Limitations open for the investor.

• Failure for an investor to properly report income passed down on Form K-3, which may be income in addition to that already reported on Form K-1, may result in an underpayment of tax, exposing the partner to various penalties and interest on such underpayment.

8. Additional Burden and Complexity for US Tax Preparers

• US tax preparers are now forced to broaden their expertise to include complex international filing reporting and requirements, or they may not have the capacity nor expertise to properly facilitate certain clients with international activities.

Key Rules and Strategies for 2025

A. Early Planning and Data Collection

• Begin gathering required data early, especially for country-by-country reporting.
• Coordinate with custodians, administrators, and service providers to ensure all necessary information is available.

B. Evaluate Filing Exceptions

• Assess whether the company qualifies for the domestic filing exception.
• If domestic filing exception does not apply, separately assess which sections of Forms K-2 and K-3 are required to be completed and which can be excluded.
• If relying on an exception, ensure all notification and documentation requirements are met, and maintain records in case of IRS inquiry.

C. Investor-Level Considerations

• Investors should separately evaluate their international tax filing requirements with their US tax advisors based on Form K-3. Tax treatment of these items may vary based on partner entity classifications, prior tax elections, ownership thresholds, and other various facts and circumstances.

• Investors should discuss potential available elections (including but not limited to the IRC 962 election, QEF election, MTM election) with their US tax advisors to optimize their US and global tax situation.

• Corporate partners should connect with a US tax advisor to ensure they are utilizing potential available permanent tax deductions such as the IRC 250 FDII deduction and IRC 250 GILTI deduction, if eligible.

• Corporate partners should connect with a US tax advisor to evaluate whether they are subject to additional US tax regimes, such as Base Erosion Anti-Abuse Tax (“BEAT”).

• Foreign investors should connect with a US tax advisor to ensure they are appropriately reporting only necessary income including but not limited to US FDAP income and Effectively Connected Income. Foreign partners should request relevant forms from the partnership regarding withholding on income (i.e. Forms 1042-S, Forms 8805, Forms 8288).

• Investors should request Form K-3 early from the partnership to provide sufficient time for compliance if they expect to need additional information on international items, including if they expect to be filing Form 1116 or Form 1118 to report foreign tax credits.  

• Investors should connect with a US tax advisor to track certain tax attributes separately, including but not limited to Previously Taxed Earnings and Profits of a Controlled Foreign Corporation, IRC 962 Earnings and Profits, and Tax Basis.

Conclusion

Schedules K-2 and K-3 mark a significant shift in flow-through international tax reporting. In 2025, partnerships and S corporations must stay ahead by understanding the requirements, gathering the necessary data, and ensuring compliance. With increased IRS scrutiny, complex reporting, and substantial penalties for noncompliance, the stakes are high. Early planning, strong systems, and clear communication with partners are key to mastering these forms, and working with tax professionals can provide valuable assistance in navigating the complexities and ensuring full compliance.

How Bennett Thrasher Can Help

As international tax reporting becomes more complex, our team is ready to help you navigate the evolving requirements for Schedules K-2 and K-3. For more information, you can contact one of our International Tax Advisors: Molly Johnson, James Parks or call 770.396.2200.

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