Compliance Relief: IRS Expands Schedules K-2 and K-3 Domestic Filing Exception

Since their inception in 2021, Schedules K-2 and K-3 have been a topic of great discussion and scrutiny amongst tax practitioners and pass-through entity (partnership and S corporation) owners. Schedules K-2 and K-3 were launched by the Internal Revenue Service (IRS) in tax year 2021 with the goal of providing both the IRS and pass-through entity owners with items of international tax relevance. Prior to their debut, foreign reporting to pass-through owners was often done inconsistently among practitioners and not transmitted to the IRS in a useful format for analysis.

Schedules K-2 and K-3 can be time consuming to fill out for tax practitioners, and in many circumstances, do not provide information that is useful and relevant to pass-through owners. This is most often the case when a pass-through only has U.S./minimal foreign investments, and U.S. investors as partners/members. The IRS anticipated this initially and included a domestic filing exception, providing the conditions for which a pass-through entity would not need to provide a schedule K-3 to partners/members. However, this exception often did not apply to the most commonly employed structures in pass-through investing.

The initial domestic filing exception had two principal criteria; 1) The pass-through had no or limited foreign activity, and 2) All the direct partners of the pass-through were considered U.S. citizens/resident aliens, which includes individuals, domestic estates, domestic grantor/non-grantor trusts, S corporations with a single owner, or a disregarded single-member LLC with a U.S. owner (the full criteria can be found on the IRS website). This list notably excludes partnerships and S corporations with multiple owners.

In July 2025, the IRS expanded the domestic filing exception in two meaningful ways for tax year 2024 and beyond. First, domestic partnerships that only have members who fall under the definition of a U.S. citizen outlined above are now considered U.S. citizens/resident aliens for purposes of the domestic filing exception. Multi-owner S corporations are now rightfully included as well, as one of the requirements for being an S corporation shareholder is being a U.S. citizen/resident individual or entity.

Second, the IRS introduced a Small Partnership Filing Exception (identical to question 4 on Schedule B of Form 1065) if a partnership meets the following conditions: 1) the partnership’s total receipts for the tax year were less than $250,000, 2) the partnership’s total assets at the end of the tax year were less than $1 million, 3) schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return, and 4) the partnership is not filing, and is not required to file, Schedule M-3.

Please note that owners of a pass-through entity that meets the domestic filing exception and does not issue Schedule K-3 still retain the ability to request it from the entity.

Anchin Observation

The updated domestic filing exception criteria is impactful for pass-through owners. As mentioned above, some of the most prominent structures were previously disqualified from using the exception. Currently, it is very common for even the smallest and simplest of pass-through vehicles to have partners who are partnerships, LLCs taxed as partnerships, and S corporations. In the fund landscape, it is often the case that the general partner/managing member is formed as a pass-through entity (commonly an LLC taxed as a partnership).

With the expanded scope of the exception, many more pass-through entities will now qualify. This will streamline compliance, make the reporting process more efficient, and avoid providing partners with extraneous forms and information. The small partnership filing exception is also notable, as pass-through entities that meet this criteria are the least likely to have a robust compliance system in place to issue Schedules K-2 and K-3.

In updating the domestic filing exception, the IRS is narrowing the scope of who must comply with Schedules K-2 and K-3 to those who have relevant foreign reporting and freeing those who were previously caught in the wide net of the original filing requirements. This should yield a positive benefit both for the IRS and the taxpayer. For those who have not yet filed 2024 tax returns, this update provides relief heading into the September 15^th extended pass-through entity deadline, as pass-through vehicle owners can potentially receive the information to file their return in a timelier manner and will not be bogged down by K-3 forms which contain information that is not relevant.

For more information on the expanded domestic filing exception, please reach out to George Teixeira, Matthew Talia, or your Anchin Relationship Partner.