Yes, even if a domestic partnership or S corporation has no foreign partners or foreign activities, there are scenarios where Schedules K-2 and K-3 reporting is still required. Here are some examples:
Example 1: Foreign Tax Credit Claim by a Partner
Scenario:
- U.S. citizen A and U.S. citizen B own equal interests in a domestic partnership.
- The partnership has no foreign source income, no assets generating foreign source income, and does not pay or accrue foreign taxes.
- In Year 1, A pays $2,000 of foreign income taxes on passive category income reported on a qualified payee statement. A has no other foreign source income or foreign taxes.
- B does not pay or accrue any foreign income taxes.
Requirement:
- Because A must complete Form 1116 to claim a foreign tax credit, the partnership must complete the relevant portions of Parts II and III of Schedules K-2 and K-3 for A.
- The partnership must report A's share of the partnership’s assets and income to help A determine the foreign tax credit limitation.
Example 2: Allocation and Apportionment of Expenses
Scenario:
- U.S. citizen A and U.S. citizen B own equal interests in a domestic partnership.
- The partnership has no foreign source income, no assets generating foreign source income, and does not pay or accrue foreign taxes.
- In Year 1, A pays $2,000 of foreign income taxes on passive category income reported on a qualified payee statement. A has no other foreign source income or foreign taxes.
- B does not pay or accrue any foreign income taxes.
- A has $5,000 of expenses described in section 1.861-8(e)(9) which must be ratably apportioned based on A’s gross income, including its distributive share of the income of the partnership.
Requirement:
- The partnership must complete Schedule K-2, Part II, and Schedule K-3, Part II for A to provide the necessary information for A to apportion expenses and determine the foreign tax credit limitation.
Example 3: Interest Expense Apportionment
Scenario:
- U.S. citizens A and B own equal interests in a domestic partnership.
- The partnership has no foreign source income, no assets generating foreign source income, and does not pay or accrue foreign taxes.
- In Year 1, A pays $2,000 of foreign income taxes on passive category income reported on a qualified payee statement. A has no other foreign source income or foreign taxes.
- B does not pay or accrue any foreign income taxes.
- A has interest expense of $5,000, and the partnership does not have interest expense.
Requirement:
- The partnership must complete the relevant portions of Parts II and III of Schedules K-2 and K-3 for A to provide the necessary information for A to apportion interest expense and determine the foreign tax credit limitation.
Example 4: Partner's Gross Income for Expense Allocation
Scenario:
- U.S. citizens A and B own equal interests in a domestic partnership.
- The partnership has no foreign source income, no assets generating foreign source income, and does not pay or accrue foreign taxes.
- In Year 1, A pays $2,000 of foreign income taxes on passive category income reported on a qualified payee statement. A has no other foreign source income or foreign taxes.
- B does not pay or accrue any foreign income taxes.
- A has $5,000 of expenses described in section 1.861-8(e)(9) which must be ratably apportioned based on A’s gross income, including its distributive share of the income of the partnership.
Requirement:
- The partnership must complete Schedule K-2, Part II, and Schedule K-3, Part II for A to provide the necessary information for A to apportion expenses and determine the foreign tax credit limitation.
Summary
In these examples, the partnership or S corporation must complete Schedules K-2 and K-3 to provide partners with the necessary information to claim foreign tax credits, allocate and apportion expenses, and determine the source of income. This requirement applies even if the partnership or S corporation itself has no foreign activities or foreign partners.
Sources:
Instructions for Form 1065 (2023)
Instructions for Form 1120-S (2023)
Partnership Instructions for Schedules K-2 and K-3 (Form 1065) (2023)
