Schedules K-2 & K-3 with a focus on the Foreign Tax Credit for individuals - YouTube video text script

Michael Smith: All right, I see it's the top of the hour. For those of you who just joining, welcome to today's webinar Schedules K-2 & K-3 with a Focus on the Foreign Tax Credit for Individuals. We're glad you're joining us today. My name is Michael Smith, and I'm a Senior Stakeholder Liaison with the Internal Revenue Service, and I'll be your moderator for today's webinar, which is slated for 120 minutes.

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We're going to take some time and test this polling feature. So here's your opportunity to make sure your pop-up blocker is not on, so that you can receive the polling question throughout the presentation. And the question is very simple. How many times have you attended an IRS National Webinar with us? Just give you a few seconds to read through that. Right folks, then I am getting some feedbacks that we're having some audio trouble here, so bear with me. I'm going to attempt to switch phone here. Okay, and while that polling question is up, go ahead and make your selection.

We have A, this is your first time attending with us; B, you've attended one through five with us in the past; C, six through 10; D, 11 through 15 or E, you have been with us for 16 and more national webinars. So please take a moment and click the radio button that best corresponds your answer. And just to make sure everybody gets that question. I’ll recap one more time just to give us some additional time. How many times have you attended an IRS National Webinar? Just give you a few more seconds to make the selection. Okay, we're going to stop the polling now and let's see how often you've attended a national webinar.

Let me just check in with my tech team. Let's see if we can get those response rate. Right, so those are coming in now first time attendees, it looks like 19% of you first time. You're definitely welcome. We're glad you're joining us today and let's see here. So hope to have been with us one through 5 times, 29%; six through 10, 13%; 11 through 15, 9%; and 16 or more national webinars, 31% of you are largest group. So definitely thank you for coming back and thank you for attending these webinars and to our first timers especially, thank you for joining us and we hope to see you back in the future.

All right, I hope you received the polling question and you're able to submit your answer. If not, now is the time to check that pop-up blocker. Make sure you have it turned off. All right again, welcome and we're glad you're joining us for today's webinar. Before we move along with our session, let me just make sure everyone's in the right place. Today's webinar is Schedules K-2 & K-3 with a Focus on the Foreign Tax Credit for Individuals and this webinar is scheduled for approximately 120 minutes.

Let me introduce today's speaker. We have with us Jim Wu, a Senior Revenue Agent in Large Business & International specifically, and it's Withholding Exchange International Individual Compliance Division in the Foreign Tax Credit Practice Network. And Jim joined the IRS in 2010. We also have Charles who goes by Andy McManus, and he's a Senior Revenue Agent in the Partnership Practice Network of Pass Through Entities, Large Business and International. He coordinates campaigns, assists with the development and review of forms and publications relating to partnerships and provides assistance to the field on issues involving partnerships including partnerships with international operations.

We have Karen Cate, Karen is a Senior Advisor in the IRS Office of Associate Chief Counsel International Division. In this role she assists with controversy, guidance, IRS publication and other matters with respect to international tax, in particular the Foreign Tax Credit and foreign corporation area. We also have Jeffrey Parry, the Senior Council in the IRS Office of Associate Chief Counsel International. He assists with controversy, guidance, IRS publications and other matters with respect to international tax in particular for Foreign Tax Credit.

Now at this point I am going to turn it over to Jim. So Jim, if you're all set, microphone is all yours.

Jim Wu: Thank you, Mike, and welcome everyone to today's webinar. And today we want to accomplish a few things. First we want to provide an overview of the new Schedules K-2 and K-3 and their purpose. And then we're going to discuss Part I, II, and III of each new schedules and also explain an exception to filing the Schedules K-2 and K-3 from the flow through entities perspective. And finally, we want to have a discussion on why U.S. individual partner or shareholder may want to request a Schedule K-3, especially with respect to the Foreign Tax Credit. Next slide please.

Here are the, acronyms that are relevant to today's webinar and they're fairly straightforward. FTC of course is Foreign Tax Credit; IRC, Internal Revenue Code; TCJA, Tax Cuts and Jobs Act; and finally USP Domestic Partnership. And I think we already have our first polling question, Mike.

Michael Smith: All right, thanks Jim. I'm actually going to hand it over to Karen. I'm getting some feedback that I'm having some audio trouble here. So, Cheryl, if you are, can you take care of this polling question for us?

Cheryl Jackson: All right, Mike. Audience I know you're ready. Here's our first Polling Question. The acronym for the unit within the IRS that primarily handles withholding issues, international individual compliance issues and exchange issues is which of the following: A, WIIC; B, TCJA; C, WEIIC; D, FTC. Take a moment and click the radio button that best answers the question. I'll give you a few more seconds to make your selection. Count seven seconds, okay. Okay, we're going to stop the polling now and we'll share the correct answer on the next slide. And the correct answer is C. I see that 32% of you answered, responded to the C.

Andy, can you clarify and explain what's going on with that on referring C?

Charles “Andy” McManus: Sure. Thank you. So the question asks, what is the acronym for the unit in the IRS that handles withholding issues, international individual compliance and exchange issues? And the answer is C, Withholding Exchange and International Individual Compliance. So WEIIC is withholding exchange, the acronym is for Withholding Exchange and International Individual Compliance. Thank you.

Cheryl Jackson: Okay, Jim. Back to you.

Jim Wu: Okay, thank you, Cheryl. I'm going to start by briefly discussing the purpose of the two new Schedules K-2 and K-3. With introduction of the TCJA in 2017, international tax became even more complicated and because of the consistent lack of details provided by pass-through entities on international transactions, the IRS began to address this problem. Schedules K-2 and K-3 are the result of this undertaking. The new schedules must be completed starting in a 2021 tax year. Previously almost all international tax information was provided in white paper format as part of Line 16, Foreign Transactions, and Line 20(c) Other items and amounts, on the Schedule K-1.

The new Schedules K-2 and K-3 will increase international tax information provided in an electronically filtered format. Prior versions of the Schedules K and K-1 did not require any specific format to provide the international tax information resulting in what could be described as a confusing array of statements attached to the Schedule K and K-1. The new Schedules K-2 and K-3 provide greater certainty and consistency helping partners and shareholders to voluntarily comply with their filing and reporting obligations.

The Schedule K-3 is essentially the mirror image of the K-2, but from the partner’s distributive share perspective. For example, the new Schedule K-3 provides information necessary for individual partners or S Corporation shareholders to figure their Foreign Tax Credit on Form 1116 in more of a consistent format. There are also Schedules K-2 and K-3 for Forms 1120-S for S corporations and Form 8865 for certain U.S. partners of foreign partnerships.

There's no question that reporting, the reporting of international transactions is now required in a more prescribed format on the Schedules K-2 and K-3. Line 16 of the Schedule K, both the Forms 1065 and 8865 now has a box for the partnership to check and then complete Schedule K-2 and K-3 for a partnership that has items of international tax relevance. It no longer requires reporting a foreign transaction on Line 16 and makes a reference to the Schedule K-2 for reporting details of international tax relevance.

In like manner Line 16 of the Schedule K-1 for both Forms 1065 again and Form 8865 makes a reference to the Schedule K-3 as a check box for a partnership to indicate to the partner the attachment of the Schedule K-3. Line 14 of the Schedules K and K-1 of the Form 1120-S have the same check boxes.

I'm going to turn now over to Karen. She will now go over the Schedule K-2 and K-3 in more detail. Karen?

Karen Cate: Thank you, Jim. So now there are currently 12 parts to the Form 1065, Schedule K-2 and 13 parts to the Form 1065 Schedule K-3. The Form 1120-S Schedules K-2 and K-3 each have less parts than the Form 1065 Schedules K-2 and K-3 and that is because not all of the parts are applicable to an S Corporation. Similarly, there are less parts to the Form 8865 Schedules K-2 and K-3. In this webcast we are focusing on Part I, II, and II. These parts cover the same information on each of the Forms 1065, 1120-S and 8865 Schedules K-2 and K-3 as applicable.

We'll start with Part I. Part I require the partnership to report items that are not specifically reported elsewhere on the Schedules K-2 and K-3, If any boxes are checked on Part I, the partnership should have attached statements to the Schedule K-3 with additional information not otherwise reported on the Schedules K-2 and K-3. Part I generally has three boxes that may be relevant to a U.S. individual partner’s or U.S. shareholder’s Foreign Tax Credit determination. These include Box 1 gain on personal property sale, Box 4, foreign tax translation, and Box 5, high taxed income.

The next slide is a screenshot of Part I. The boxes that are relevant for a U.S. individual partner’s or shareholder’s Foreign Tax Credit determination are highlighted. I will focus on one of those boxes listed on the slide and that is Box 1, Gain on personal property sale. Part I, Box 1 requires the partnership to provide information concerning personal property sold. The information is presented in the format of Table 1, which is shown on this slide. If the partnership sells personal property, the source of gain is generally determined as if the property is sold by the partners; that's under Code Section 865. Generally if the partner is a U.S. resident for tax purposes, the gain on sale of personal property is U.S. sourced. Conversely, if the partner is a non-resident for tax purposes, the gain on the sale is foreign sourced.

However, there is an exception under Section 865(g) that states that a partner who is otherwise a U.S. resident, is considered a non-resident for sourcing purposes if an income tax equal to at least 10% of the gain derived from the sale is actually paid to a foreign country with respect to that gain. The information provided by the partnership in Table 1 will help the partner make this determination as to whether a 10% tax has been paid on the gain.

Part I, Box 1 on Schedule K-3 of the Form 1120-S applies in the same manner for S corporations and their shareholders. And then Box 1 of Part I on Schedule K-3 of the Form 8865 applies in the same manner for certain foreign partnerships and their U.S. partners. The IRS revised the information required to be provided in Table 1 in tax year 2022 as compared to 2021. Unlike in 2021, in 2022 when the partnership completes Table 1, just gain is required to be reported rather than both proceeds and basis. Also, instead of reporting the date of the sale of the property, if the gain is capital, the partnership will now report whether the gain is long-term or short-term.

If there is a mix of long-term and short-term gain on stock sales in a single country, a separate subgroup for the total of each should be reported on separate lines. Finally, the partnership may combine box sales by country instead of listing each stock sale separately for that country.

Now I will turn over the presentation to Michael for another polling question.

Michael Smith: All right, great. Thanks Karen. Okay, audience on your screen you should see polling question number two coming up and this question reads, How many parts does Form 1065 Schedule K-3 have? And your options are 10, A; B, 11; C, 12 or D, 13. Now I will read that again just to make sure everybody has time to hit the popup and answer the question, may also provide a few seconds to check the schedule to get the correct answer. So that question reads How many parts does Form 1065 Schedule K-3 have? And your options are A, 10; B, 11; C, 12 or D, 13. So take a moment and click the radio button that best answers the statement and I'll just give everyone a few more seconds to make your selection.

Okay, let's stop the polling now and I'll share the correct answer on the next slide. And you should be able to see on your screen the correct answer was D, so 13 parts to Schedule K-3 for the Form 1065. Now let me check in with the team and see how we did on that one. Okay, it looks like we had a correct response rate of 49%. I know these are tough questions, they're complicated. I will try to give you a little more time to answer the following questions coming up. But yes, let's see.

Andy, are you online with us? Can you kind of clarify a little bit more or explain that question in a little more detail for us?

Charles “Andy” McManus: Sure. Thank you, Mike. So there is 13 parts to the Schedule K-3. Those are Partnership’s Other Current Year International Information, it is Part I, those are check boxes, Part II, the Foreign Tax Credit limitation, Part III is other information for the preparation of Form 1116 or 1118, Part IV is information on the partner’s Section 250 Deduction with respect to FDII, Foreign Derived Intangible Income, and then that also contains information on the deduction eligible income and QBAI, the FDII calculation, Part V is information on distributions from foreign corporations to the partnership, Part VI is information on the partners 951(a)(1) and 951A inclusions, Part VII is information to complete Form 8621, Part VIII is the Partner's interest in foreign corporation income Section 960, Part IX is the partner's information for BEAT, base erosion anti-abuse tax Section 59A, Part X is the foreign partner's character and source of income and deductions. And Part XI is 871(m) covered partnerships, XII, is reserved for first future use. This is, I'm reading off the K-2 and the first section you've got check boxes for which parts apply. That's from the K-2 and then the K-3 has an additional part which gives the XIII section.

Michael Smith: Okay, got you. So that that one little extra section may, might have been what tripped us up. So okay. But thank you, thank you very much for clarifying. All right, looks like we are turning it back over to Karen. So Karen, if you are all set, you have the microphone.

Karen Cate: Thank you, Michael. So now we are going to move from Part I to Part II. Part II is included on the Schedules K-2 and K-3 for all of the forms, Forms 1065, 1120-S and 8865. The purpose of Part II is to facilitate the computation of the Foreign Tax Credit limitation by the partner. The individual partner computes the Foreign Tax Credit limitation on Form 1116. Part II is divided into two sections, gross income and deduction. These two sections provide the information to input in Part I of the Form 1116 where foreign source income and deductions are reported.

On the next two slides, we have a screenshot of Part II, Section 1 of the Schedule K-3. This is where the partnership reports the distributive share of the partnership gross income for the Foreign Tax Credit limitation computation because the separate Form 1116 is required for each category of income, Column (b) through (e) of the Schedule K-3 show the various categories of income, the most common, which, of which are identified. Column (f) is income sourced by partner, for example as mentioned previously, generally sourcing of the sale of personal property depends on the residency of the partner.

So the individual partner will have to make their own determination as to the sourcing of any gain in this column. The types of income such as sales and gross income from the performance of services follow the types of income listed on the Form 1065, Form 1118, which is the Foreign Tax Credit form for U.S. Corporations and the Form 1116. The Form 1116 doesn't list each of these types of income separately. However, each of these types of income generally follow different rules for how to determine the source of such income. Therefore, that is another reason why such income amounts are reported separately. Under each type of income in Section 1, A, B and C are where the partnership indicates the name of the country generating the income. Refer to the link in the instructions for the two letter code for the country in question, this provides the country name that is required to be included on Form 1116 under the three columns of that form.

If a type of income is sourced from more than three countries, a statement is attached to expand Schedule K-3, Part II for that type of income to report the additional country. The partnership may have reported country code XX for Column (f), if the partner, as opposed to the partnership, is required to determine the source of the income. The partner should determine the source country and report that country as opposed to code XX on the Form 1116. Just for illustration of the schedule, we skipped lines 8 through 15 of the form on this slide.

The next slide is the continuation of Section 1. Notice that Line 24 is the sum of all of the various types of gross income listed above. The detailed information in Part II Section 1 is essential for completion of the Form 1116. While the prior discussion has focused on the Form 1065 Schedule K-3, note that Part II Section 1 looks the same and Section 1 looks the same for the Form 1120-S and Form 8865 Schedules K-3.

So this next slide shows Part II, Section 2. Section 2 is where the partners distributed share of the partnership’s deductions are reported for the partner’s Foreign Tax Credit limitation computation. The deductions listed on the Schedule K-3 match the expenses separately listed on the Form 1065, Form 1118 and Form 1116. These deductions are separately reported generally because there's a different rule for each expense to be allocated in apportioned to foreign source income.

In addition, the deductions are separately reported in some cases because there is a specific partnership rule for that deduction. The deduction in Part II, Section 2 of the Schedule K-3 should be reported by the partner on Lines 2 through 6 of the Form 1116. The instructions provide a lot of details for these line items including where is to place the deduction on the Form 1116. Similar to Section 1, the partnership will report the deductions in Section 2 to the partner by separate category of income. However, the partnership is not required to report the deduction by country. Again, while the prior discussion has focused on the Form 1065 Schedule K-3, note that Part II, Section 2 looks the same on the Form 1120-S and Form 8865 Schedules K-3.

This next slide is the continuation of Section 2 and the deductions. We will now move from Part II to Part III. Part III has five sections, Section 1 and Section 2 of Part III report Research and Experimental expenses and Interest Expense, respectively, and provides information to the partner so that the partner can allocate and apportion each of these expenses. This is because the Code and Regulations provide specific rules for how to allocate and apportion these expenses. These deductions are reported on Part I, Lines 2 through 6 of the Form 1116. The instructions provide guidance on how to use the information reported on Schedule K-3. Section 3 is not applicable to individual partners or shareholders, so is not covered in this presentation.

Section 5 contains miscellaneous information that a partner may need to accurately compute its Foreign Tax Credit limitation. This information reported in Section 5 is not as widely applicable, so this presentation will not focus on this section.

The next slide will focus on Section 4 of Part III which will apply to most partners claiming Foreign Tax Credits. Note that the Schedule K-3, Part III of the Form 1120-S only includes the sections for Research and Experimental expense, Interest Expense and Foreign Taxes because these are the parts that are applicable for S Corporations and their shareholders. The Schedule K-3 Part III of the Form 8865 looks the same as the Form 1065, Schedule K-3 Part III.

The next slide shows Section 4 of Part III and that is where all information related to foreign taxes paid or accrued by the partnership is reported. This pertains to Part II of the Form 1116. The Schedule K-3 provides the distributive share of the foreign taxes to each partner. The A through F line items under Line 1 are the country codes that are entered by the partnership.

The country codes are the same as those mentioned earlier with respect to gross income. Line 2 of Section 4 report any reduction in foreign taxes. This corresponds to Line 12 of the Form 1116. Line 3 reports any foreign tax redeterminations which corresponds to the new Schedule C of the Form 1116. Line 3 requires new reporting in tax year 2022 with respect to contested taxes. The partner may elect to claim a Foreign Tax Credit for the distributive share of such contested foreign income tax liability.

To make the election to claim the Foreign Tax Credit, the partner will need to file Form 7204. See the instructions for Forms 1116 and the instructions to Form 7204 for additional information. Note that the partnership has reported your taxes by separate category of income. Further, the partnership reported the type of tax. The type of tax is separately identified on the Form 1116 and includes withholding taxes on dividends, rent and royalties and interest. The type of tax also includes non-withholding taxes.

The next slide is a continuation of Section 4 showing the passes and general categories of income on which foreign taxes are paid or accrued. The instructions to Form 1065 Schedule K-2 and K-3 provide explanations of how to use this section to complete Form 1116. Note that the format of this section is the same on the Forms 1120-S and 8865 Schedule K-3 Part III. Now I will turn over the presentation to Jim.

Jim Wu: Thank you, Karen. That was very informative. I'm going to switch gears a little bit here and talk about the domestic filing exception starting in tax year 2022, in certain cases where domestic partnership or S Corporation engages in no or limited foreign activity, the Schedules K-2 and K-3 are not required to be filed by the flow-through entity. This will alleviate some administrative burden for some domestic partnerships and S Corporations. However, this means that you as the partner or S Corporation shareholder will not be receiving the Schedule K-3 and later on we will explain why you may want to request Schedule K-3 nonetheless, even if the passthrough entity qualifies for this exception.

So on this slide and then continuing on the next slide is a flow chart that will guide you through the various steps to see if the pass through entity qualifies for the domestic filing exception and is therefore not providing you with the Schedule K-3. And note that all four of the following criteria must be met for the domestic partnership or S Corporation to use this exception.

So the first criterion is that there is no or limited foreign activity at the domestic flow-through entity level. And what does that mean? What does it mean to have no or limited foreign activity?

Well, let's define what is a foreign activity first and it includes the following. There are no foreign income taxes paid or accrued, no foreign source income or loss, no ownership interest in a foreign partnership, no ownership interest in a foreign corporation as defined in Section 7701(a)(3) and (a)(5), no ownership of a foreign branch and no ownership interest in a foreign entity that is treated as disregarded or separate from its owner.

Okay, so that's the first criteria. No foreign or limited foreign activity. The second criteria is that all partners or shareholders must be U.S. citizens, lawful resident alien or Green Card holders or certain other entities including domestic trusts and domestic estates.

The third criterion is that a notification must be sent to the partners by the date the passthrough entity furnishes or provides the Schedule K-1. This notification can be provided on the Schedule K-1. The notification must state that the partnership having met the first two criteria, the first two criteria will not provide the partner with a Schedule K-3, unless the partner makes a request for it. Similar requirements apply of course to the S Corporation.

Okay, let's continue on the next slide. The final criterion in order for the domestic filing exception to apply is that no Schedule K-3 requests were made on or before one month of the filing of the Form 1065 including extensions. But having said that, you as the partner or shareholder have the right to request the Schedule K-3 at any time. The partnership or S Corporation must provide the Schedule K-3 to you when it provides you with the Schedule K-1 or if you did not timely make a request for the Schedule K-3 one month prior to the filing of the Form 1065 or the Form 1120-S. The pass through entity must provide you nonetheless with the Schedule K-3 within one month of receiving your request or by the due date or by the date the partnership or S Corporation files the Form 1065 or the Form 1120-S, whichever is later.

I know these rules are very nuanced. So, we provided here a flow chart and hopefully this flow chart will be a very useful guide. Also, there are examples in the Schedule K-2 and K-3 instructions, which are very informative in demonstrating how the domestic filing exception works.

So, at this time I'm going to turn the presentation over to Jeff. Jeff?

Jeffrey Parry: Thank you, Jim. I want to talk about if the partnership meets the domestic filing exception, what does that mean for you? It means the pass through entities are not going to be required to report the following information to their owners. First is passive category, creditable foreign taxes that are not more than $300. If the partner has reason to believe that the partnership has some of these taxes less than $300 and wants that information so that they can claim a credit for those taxes, they will need to request the K-3 information from the partners.

Other information that the partnership will not be reporting is information on Part I, II and III that may increase your foreign tax limitation on a Form 1116 or that may be necessary to correctly calculate that limitation. Some of this information that you might need is to pass through entities U.S. source gross income, the pass through entities assets that generate U.S. source income.

This is described in more detail in the instructions and for the Schedules K-2 and K-3, but I want to go through, why you would need that information, particularly that information about U.S. source gross income and assets that generate U.S. source income as well. In a nutshell, these are going to be relevant for determining your Foreign Tax Credit under 1116 if you are otherwise earning foreign source income and paying Foreign Tax Credits on your own. So we're going to go through a couple of examples on the following slides to illustrate the conditions under which this information will be helpful to you and why you might want to request it.

But before we go through these examples, I want to turn it back over to Michael for the next polling question.

Michael Smith: All right, great. Thanks, Jeff. Okay, audience Polling Question Number Three should be coming up. This is a long one, so I'll give you a plenty of time to read through all of these options. So this question reads if the Domestic Filing Exception applies, which of the following is true: A, the partnership is not required to file Schedules K-2 and K-3 and is not required to furnish a completed Schedule K-3 to the requesting partner. And again this is if the Domestic Filing Exception applies, which of these is true: B, the partnership is required to file Schedules K-2 and K-3 and it's also required to furnish Schedules K-3 to every partner; C, The partnership is not required to file Schedules K-2 and K-3 and is required to provide Schedule K-3 to the requesting partners completed with the requested information on the later of the date the partnership files the Form 1065 or one month from the date the request is received. And finally D, the partnership is not required to file Schedules K-2 and K-3 and is required to provide Schedule K-3 to the requesting partners completed with the requested information one month from the date the request is received.

I will give you a few seconds of silence, so you can all read through those yourself and take a moment and click the radio button when you've selected the right answer. All right, just checking on the back end. We are receiving answers, but take your time, read through it. I'll give you a few more seconds. And I know this is a long one. They, they are challenging you today. All right, I'm seeing a lot of responses, but let's just give a five more seconds. Okay? Take your best final answer. Now click the button, the best answers the statement, and we are going to stop this poll now, and then we'll share the correct answer on the next slide.

All right. Okay. Hopefully you can see, so if the Domestic Filing Exception applies, C, would be true. The partnership is not required to file Schedules K-2 and K-3 and is required to provide Schedule K-3 to the requesting partner with the information on the later of the date the partnership files the Form 1065 or one month from the date the request is received. So let's see how we did on that one. All right. Okay team, 55% of you answered question C correctly. I know that was a challenge.

Andy, are you on, can you give us a little bit more clarification on that one?

Charles “Andy” McManus: Thank you, Michael. Yes, so for this question you want to refer to the flow chart and I know some of you might not have the slides available in front of you to complete this, which might have made it a tricky question, but if you refer to the flow chart that was provided a couple slides back, that flow chart provides the complex rules related to the timing of when the flow through entity must provide the K-3 to the requesting partner. And if we analyze this answer, there's really two parts to the requirement.

For the first thing is that you do not have to file a K-2 or K-3 if you meet the Domestic Filing Exception. So it gets you out of, it does two things. It gets you out of filing the K-2 and K-3. And the second part of it is that, you have a timing requirement and you have, if you've the partnership, you have to furnish the K-3 if requested by the later of two dates. And those dates are either the date that the partnership files the return, or one month from the date that a request is received.

So I'll turn it back over to Michael.

Michael Smith: Okay, thanks a lot, Andy. Good answer. And yes, definitely audience again, you can find a copy of this PowerPoint with that flow chart in the material section on the left side of your screen. So definitely do download that before the webinar ends.

All right, with that Jeff, I believe it is back over to you.

Jeffrey Parry: Thank you, Michael. So as promised, I'm going to go through a couple of examples now of when a partner might want to request a Schedule K-3 from the partnership, regardless of the fact that the partnership qualifies for the Domestic Filing Exception. Now, in this first example, we're going to explain why a partner might want to get the information on the partnerships U.S. source assets. And this is relevant for them doing their interest expense apportionment, and we will talk about how that factors in and can affect your ultimate Foreign Tax Credit.

So first I will go through the basic facts that we need to just background facts before we get into the analysis. First off, the partnership has no foreign activity and meets the domestic filing exceptions. So it's not otherwise required to file the K-3. Now, partner A separately pays $2,000 of foreign income taxes on passive category dividend income reported on a qualified payee statement. The tax book value of the partnership's assets is $100,000, and these are all U.S. source income producing assets A's distributive share of those assets is $50,000.

Now A, in addition to the partnership interest, A separately owns $50,000 of assets of its own. Of those assets, $10,000 generate foreign source income and $40,000 of those assets generate U.S. source income. A also has $5,000 of deductible interest expense that needs to be allocated and apportioned. A has passive foreign source income of $8,000 before taking into account any apportionment of interest expense. A's worldwide taxable income is $30,000 and A's U.S. tax liability is $5,900.

The other partner B of the partnership, does not request a Schedule K-3. And the main reason is because that partner either doesn't claim any Foreign Tax Credit separately or doesn't claim a Foreign Tax Credit that would require filing the 1116. But because A is claiming the Foreign Tax Credit on the Form 1116 partner A should request the K-3 to be assured that he's claiming the correct amount of Foreign Tax Credit and is maximizing the amount of Foreign Tax Credit. We'll see the results on the next slides of how that's calculated with and without the Schedule K-3 information.

First off, if they don't, the Schedule K-3 information, just as a background, I want to go over the interest expense apportionment rule for this deductible interest expense. It is a portion of the foreign source taxable income based on the proportionate value of the foreign assets over the value of total assets. This is because this type of interest expense is basically considered fungible, meaning it's not directly tied to anything, it's considered to support all your assets. So you allocate it to foreign source based on the proportionate amount of foreign source assets that you own.

Now, when partner A, if they not taking in account their share of USP's assets, they are only going to have $50,000 of U.S. source of total assets. So we're ignoring the 50,000 share of USP's assets. And as I said before, A's assets are divided $10,000 foreign and $40,000 U.S. So to calculate the proportionate amount of the interest expense that will be allocated to reduce their foreign source income, you multiply the total $5,000 interest expense by a ratio, which is the amount of foreign assets over total assets. So you multiply $5,000x $10,000 over $50,000. The result is $1,000 of interest expense. That's the amount of interest expense that will be allocated to reduce their foreign source taxable income.

Therefore, a foreign source taxable income is $7,000. Remember it was $8,000 before interest expense and then we reduced it by the $1000 of interest expense that is allocated to foreign source. Now with that information, we can calculate partners A's Section 904 Foreign Tax Credit limitation. Now Section 904, the principle behind the Foreign Tax Credit is that, it's meant to alleviate double taxation on your foreign source income. So Section 904 limits the amount of Foreign Tax Credit you intake to the portion of your total tax liability that is attributable to foreign source income.

In other words, we only want to relieve double tax on the foreign source income. We can't use Foreign Tax Credits to offset the liability on your U.S. source income. So to come up with the limitation, the Foreign Tax Credit limitation, you multiply your total U.S. tax liability times of fraction, which is your foreign source income over total income, and that's how you get the amount of your U.S. tax liability that is proportionately assigned to your foreign source income.

And when we do that calculation, we multiply A's total U.S. tax liability of $5,900 times a fraction of $7,000 of foreign source taxable income over their $30,000 of total worldwide income. When you multiply those numbers out, you end up with a Foreign Tax Credit liability limitation of $1,376. So even though A paid $2,000 of foreign taxes, they can only take a credit for $1,376, the portion that's attributable to the share of their liability that is foreign sourced.

All right. Now we will see how does this number, how do the numbers change when calculating the Foreign Tax Credit limitation? When you take into account your share of the partnership's assets and all of this, when you add the share of USP's assets, A's total assets now increased to a $100,000. That's their $50,000 of assets that they separately own plus their $50,000 share of the partnerships U.S. source assets. Now when you do your interest expense allocation, if you remember, you multiply interest expense, total interest expense by a fraction, which is foreign source assets over total assets.

And the only thing that's changed now in this calculation is the amount of total assets and that denominator. As a result when you multiply $5,000, now times $10,000, over a $100,000, the amount of interest expense that can reduce your foreign source taxable income is now only $500 as opposed to a $1,000, which we calculated before. So if less interest expense is being allocated to reduce your foreign source income, you will have higher foreign source income. So therefore, A's foreign source taxable income is now $7,500 instead of $7,000, which is $8,000 minus only $500 of interest expense.

So taking that into account when we do our Foreign Tax Credit calculation about the limitation under Section 904, we'll see that the only number that is changed. Now we have this formula that is multiply U.S. tax liability times foreign source income over worldwide income. And the only number that's changed now is that foreign source income in that numerator. So now we're multiplying $5,900 of total U.S. liability times the fraction of $7,500 of foreign source income over $30,000. Now the Foreign Tax Credit is $1,475. When you compare that to the limitation calculated without the Schedule K-3 information about U.S. assets of the partnership, you've increased your Foreign Tax Credit limitation by $99. So changing nothing else but getting that information, Partner A is now able to claim a higher Foreign Tax Credit by $99.

So next we are going to go through these numbers and just show you how they show up on the different forms. And keep in mind that for simplification, we're just showing you the relevant numbers. We're just showing you Part III of the Schedule K-3 that the Partner will request and where that $50,000 of assets is showing up. So you see Line 1, total amount of assets is $50,000. Total assets used for interest apportionment $50,000. So there's going to be a lot of other information on that K-3 but this is the information, this is where you look for this asset information that you're going to need.

So how does this look now on your 1116, when you calculate your Foreign Tax Credit limitation? Again, for simplicity reasons, we're only showing the effects of this additional K-3 information are going to have on the 1116. In actuality, the 1116 might look a lot more complicated than just the numbers were showing here. So first we're going to walk through what the 1116 looks like without the Schedule K-3 information, and you'll see on Line 1, that's the $8,000 of Partner A's foreign source taxable income before taking into account, interest expense.

Then on Line 6, that shows the $1,000 of interest expense that was allocated to the foreign source income. And we walk through how we come up with that $1,000. So now Line 7 will show you that the total foreign source income now is $7,000. Part II shows you the amount of taxes, total amount of taxes paid was $2,000.

When we move to the next page of the 1116, you'll see in Part III, we've carried over the $2,000 of Foreign Tax Credits, foreign taxes that were paid, that shows up Line 9 through 14. Line 15 now we see the carryover number of $7,000 from that's the foreign source income that carries down to Line 17 without adjustment. So Line 17 is a foreign source income, Line 18 is your total worldwide income, including foreign and U.S. source, and that's $30,000.

Now, when you divide $7,000 by $30,000, you come up with the number 23.3% on Line 19. That's the percentage of your total U.S. liability that is going to be treated as eligible to your foreign source income. That's the $1,376. And you see that even though up above they report $2000 of taxes paid because of this limitation below is lower than $2000, they can only claim a credit for $1,376.

Now you're going to look at the 1116 as it would be filled out when you have the information, this additional information from the Schedule K-3 that you've requested. You see on Page 1, we still got the $8,000 of foreign source income. But now down on Line 6, we see that the interest expense that's eligible to the foreign source income is only $500 instead of $1,000. And that's where we see the difference show up. And now the total foreign source income is $7,500. Part II, we still have the same amount of foreign taxes paid $2,000. That didn't change. We go to the next page of the 1116 and we see again the $2,000 carried over, that's the foreign taxes paid. Now we see on Line 15 and 17, the new higher amount of foreign source taxable income, $7,500. Now when you divide that $7,500 by the $30,000 of total income, you come up with a percentage of 25% if you recall, without the Schedule K-3 that was 23.3%.

Now the percentage is 25%. So 25% of your total U.S. tax liability is now eligible to the foreign source income and therefore you have a higher Foreign Tax Credit limitation of $1,475. That's still less than $2,000. So you're still not going to get a credit for all your taxes that you get to take a credit for $99 more of taxes than you would've been.

So that's, you get an extra $99, pay $99 less of tax because you asked for this K-3 and then which reduced your foreign source or increased your foreign source income and reduced the amount because you reduced the amount of interest expense that was apportioned to your foreign source income. So that's going to be, these numbers are low. The example is, but when they're, the numbers are larger, this is a bigger impact. And so potentially there could be a large increase in Foreign Tax Credits that you're able to take because you asked for the Schedule K-3.

All right, so that's the first example. Now we'll move on to the second example, the second example, we're not going to talk so much about changing the amount of your Foreign Tax Credit as we are going to focus on just being able to more accurately and correctly compute your Foreign Tax Credit. And this example involves, is an example of why you're going to want the K-3 to find out your gross income share of the partnership. So the first example was about wanting the asset information. Now this example shows why we might, the partner might want to get the gross income information from the partnership.

And particularly in this case, because the partnership is all U.S. source activities, it's the share of the partnership's, U.S. gross income, U.S. source gross income. Now we'll go through again, basic fact pattern. There's the basic fact, background facts that we need to show the computations and do the analysis, and we start out with very similar facts.

The first is that the USP has no foreign activity, therefore they're qualifying for the domestic filing exception. Partner A again pays the same $2,000 of foreign taxes on passive category dividend income reported on a qualified payee statement. And again, Partner B same as the other example, B does not request a K-3 because they're not claiming a Foreign Tax Credit or is not filing 1116 in order to do so. But because Partner A is claiming the Foreign Tax Credit on the 1116, they are going to want to request this K-3 to be assured that they're calculating the correct amount of Foreign Tax Credit. We'll see the results of getting this information on the next slide.

So, but we're continuing with the facts. Sorry, I meant to continue with the facts first A's distributive share of the partnership's U.S. source gross income is $50,000, A's gross income separate from this before expenses is $40,000. Of that $40,000, $5,000 is foreign source income, $35,000 is U.S. source income. A has $5,000 of expenses, that's not interest this time, but it's a type of expense that's not definitely related to any gross income and therefore is going to be allocated based on all your income proportionately. A has passive foreign source income of $5,000 before expenses, A's worldwide taxable income is $70,000. And A's U.S. total tax liability is $14,000. And as I said before, Partner B is not requesting a K-3 from the U.S. partner because they're not claiming the credit. All right, so now we'll go on and show how these numbers are needed.

This information from the partnership is needed, now because this $5,000 of expense is going to be relatively apportioned to foreign source income based on the proportionate amount of foreign source to total gross income. But in order to do this, in order to accurately do this apportionment, A needs to know what is distributive share of USP's gross income, needs to know that that's $50,000 of U.S. source income so that they can do this proportionate correctly.

If A does not have the Schedule K-3, they do not have the full information that they need to determine this distributed share of gross income. So while they might, they may have some information on the K-1, the K-1 schedule is going to include certain income and deduction information that rolls up to the partnership. The K-1 does not give you a clear total amount of distributive share of gross income. And so the K-3 is going to be what you need to get that information. And without that, you cannot determine the correct amount of foreign tax, taxable income for purposes of determining your Foreign Tax Credit limitation.

So now we will see how A is able to calculate correctly their Foreign Tax Credit limitation with the information from the K-3. So A now knows that their share of USP's gross income is $50,000 of U.S. source. So that makes their total gross income $90,000, that's $40,000 that A has separately and $50,000 of that is A's share of the partnership's U.S. source income. Now like I said this, the $5,000 of expense is going to be apportioned ratably to the foreign source income. And that's done by multiplying that expense times the ratio, which is total foreign gross income overall gross income, foreign and U.S. So when you go walk through that calculation, you multiply $5,000 of expense times $5,000 of foreign source income, over $90,000 of total income. And that results in $278 of that expense being allocated to the foreign source taxable income.

Therefore, A's total foreign source taxable income is $4,722, that's they started out with $5,000 of foreign source and they reduce it by the $278 of expense, that is apportioned to foreign source income. So now when A goes to calculate their Foreign Tax Credit limitation under Section 904, as we explained before, they take, they multiply the total U.S. liability times the fraction that is going to be foreign source income over total income.

So when they multiply the $14,000 of U.S. liability times $4,722 of foreign source income, over $70,000 of total income, the limitation comes out to be $944. So even though they pay $2,000 of foreign taxes, the credit that they can take, the Foreign Tax Credit that they can take on their return is going to be limited to $944. So, we see now with the Schedule K-3, Partner A includes the gross income in this computation, meaning that they can now correctly determine this amount of Foreign Tax Credit.

It's just a piece of the information that they wouldn't have otherwise had and their numbers would not be accurate without this information. All right, so as an example, one we're going to walk through now how this information is going to show up on the forms that you receive or file. So again, we are simplifying to just show the information that's relevant, even though there might be a lot of other information on the K-3 that if you request a K-3. For this purpose, you're looking to Part II, gross income Line 2 is going to show you your share, excuse me, your share of the U.S. partnership's U.S. source income of $50,000.

Now, when we go through the 1116 to show you how the numbers pan out here, we start with the $5,000 of foreign source income before any expenses allocated to it, we show in the next section, it shows the $5,000 of expense that needs to be allocated, which happens to also be the same amount of the foreign source income. Don't confuse those two $5,000 referring to two different amounts. So you see, it shows you the $5,000 and then on Line 2(d), it's the $5,000 of foreign income, Line 2(e) is the $90,000 of total income. And so when you divide the $5,000 by $90,000, you end up with a percentage of 5.56. And so you multiply that percentage times, the expense to come up with the $278 of expense that is eligible to the foreign source income. So now we see down to Line 6, that $278 of expense, when you subtract that from $5,000, you end up with Line 7, $4,722 of foreign source income.

In Part III, again, we see the same old $2,000 of taxes that unfortunately taxpayer never seems to be able to claim a credit for all of that. But the portion, that they don't get to claim a credit for does carryforward. So hopefully next year they can get more limitation and use it. So we go onto the next page and we see again the $2,000 of foreign taxes that carryover. And we see on Line 15, the foreign source income of $4,722, which is also carries down to Line 17, because there's no adjustment to it. And you have total worldwide income of $70,000 on Line 18. So now you divide $4,722 by $70,000 and you come up with a percentage on Line 19 of 6.74%. When you multiply that by their total U.S. tax liability of $14,000, we get $944 of Foreign Tax Credit limitation, meaning again, of the $2,000 they paid, they can only use $944 of that as their Foreign Tax Credit.

So again, by requesting the Schedule K-3 from the partnership, partner A is able to accurately determine this Foreign Tax Credit number. Without that information, they'd be trying to guess that, what their total gross income numbers were. And so this gives them certainty in knowing that they've correctly calculated the number. So these are the two examples, two prime examples for why information you might want to request this information on a K-3 from a partnership who otherwise is not required to provide you with that K-3, because they've met the domestic filing exception.

All right, so now I'm going to turn it back over to Michael for a, what I believe is our final polling question for today.

Michael Smith: That's right, yes. Polling Question number Four. And thanks a lot, Jeff. Good examples. I think that really, really helps provide some understanding on this topic too. It is complex and just like this polling question, so we have another complex question for you. So again, we'll give you some extra time. You can read through all of these possible answers. So this polling question reads, which of the following is not a reason why a partner with a partnership that meets the Domestic Filing Exception would want to request a K-3? Focus on that not in the question. We have A, the partner's distributive share of partnership assets may have the effect of increasing foreign source net taxable income determined at the partner level; B, the partner's distributive share of partnership gross income may need to be taken into account to determine foreign source net taxable income determined at the partner level; C, the partner needs to determine foreign taxes paid directly by the partner, not the partnership; or D, the partner needs to determine its share of the passive category foreign taxes paid or accrued by the partnership that are not more than $300.

So take a few moments, read through those answers carefully, and click the radio button that best answers the statement. And here again, I'm going to give you a few extra seconds, I'll let you make those selections. All right. It looks like we have responses coming in. Let me just give you five more seconds. Read through those, answer carefully. Okay, thanks everyone for answering. If you haven't answered yet, take your best guess now and we are going to stop the polling and let's share the correct answer on the next slide.

Right. You can see the correct answer there was C. So the partner needs to determine foreign taxes paid directly by the partner, not the partnership. And let's see, I'm getting word from our team now. Okay. And so audience, we had a correct response rate of 39% on that one. I know it is complex, it's a tough question. We are really challenging us today.

Andy, if you have a minute, can you give us some more detail, clarify a bit?

Charles “Andy” McManus: Sure. Thank you, Michael. So the partners should know what he paid directly in foreign taxes. And the Schedule K-3 provides that information for foreign taxes paid by the partnership. So this option C here refers to taxes paid directly by the partner. So since the partnership didn't pay those, that's information the partnership doesn't have, only the partner has it. And these other three choices are each something that the partner would know. So the partner, I'm sorry that the partnership would know. So the partner's distributed share of partnership assets. That's information the partnership knows, partner's distributed share of partnership gross income, that's something the partnership knows. The fact that the partner needs to determine its share of the passive category, foreign taxes.

So the partnership would be able to determine the amount of passive category foreign taxes paid by the partnership. So that's something only the partnership would know. So option C is the only thing that the taxes directly paid by the partner that the partner him or herself would know.

Michael Smith: Okay, it makes sense. Yes, since we have you on, I think you're going to go over some additional resources with us anyways. So if you're all set with those.

Charles “Andy” McManus: Thank you, Michael. Yes, the resources for the Schedule K-2 and K-3 are partnership instructions for the K-2 and K-3, those are the instructions to Form 1065. And then we have partner level instructions for the partner, just for the partner. Those are instructions for Schedule K-3, right. So those are instructions. The partner can use to interpret the information on the K-3. We have S Corporation instructions for the Schedule K-2 and K-3 for Form 1120-S that the S Corporation can use to prepare the K-2 and K-3. And then we have S, we have the shareholder instructions for the Schedule K-3 that the shareholder can use, a shareholder of an S Corp can use to prepare their return using the information from the K-3 for the 1120-S.

And then finally we have the instructions for the K-2 and K-3 for Form 8865. And I think Michael, we'll take it from here for the Q&A.

Michael Smith: Yes, absolutely. Thank you for that, Andy. Good to have all the resources in one place on one slide. Okay. Hello again everyone. It is me, Michael Smith. And at this time we are going to begin our question-and-answer session. Earlier I mentioned we do want to know what questions you have for our presenters. So here's your opportunity. If you have not input your questions, we do still have time. Go ahead and click on the dropdown arrow next to the ask question field and type in your question and be sure to hit send. We have a number of questions in already and thank you to those participants who have entered your questions. We always appreciate the questions because we use those to improve these webinars in the future as well. We want to know what tax practitioners are asking about, what challenges you're having and what you want clarification on.

Now let's continue. Jim, Andy, Karen, and Jeff are all staying on with us to answer your questions. And they've been busy in the background kind of looking through some of the questions we already have. So the, we'll be providing answers as we go here. Now, one thing before we start, we likely won't have time to answer all the questions submitted, but we will answer as many as time allows. And let me also cover the continuing education details, while you input those questions.

If you are participating with us today to earn a certificate and the related continuing education credit, you'll qualify for two credits by participating for at least 100 minutes from the official start time of the webinar, and you'll receive an one credit by participating for at least 50 minutes from the official start time of the webinar. So that means the first few minutes of chatting and administrative items before the top of the hour did not count towards the 100 or 50 minutes. So please stay on with us to meet those time limits.

All right, let's get started. So we can get to as many questions as possible. Andy, since I have you here, I'm just going to start with yours. So this first question reads, is it right that the 1120-S Schedules K-2 and K-3 are mirror images of the 1065 schedules on K-2 and K-3?

Charles “Andy” McManus: Thank you, Michael. So in many instances, the Form 1120-S Schedule K-2 and K-3 are the same as the 1065 K-2 and K-3, however, refer to the instructions for the schedules because not all parts of the 1065 schedules were necessary for the 1120-S, but there were some things that only applied to the 1065 and not to the 1120-S.

Michael Smith: Okay. All right, thanks for that. Let me give you another one right away. This one's a little longer. Let me know if you need me to repeat any of this, but I think you have access to these too so you can see what I'm saying. But this question reads, you said that when filling out Table 1 per property sales, that the partnership may combine stock sales by country. Instead of listing each stock sale separately for that country. Can the partnership combined sales of other types of personal property?

Charles “Andy” McManus: So the answer to this one is no. The exception for stock sales was allowed, because of the potential high volume of stock sales. And so for example, in an investment partnership. We don't think that partnerships will have similarly high volumes of sales of other types of personal property.

Michael Smith: Okay. Okay. All right. Thank you for that. Okay, let's see. Karen, this next question is coming for you. So this question reads, why do you report by country when that appears to be irrelevant? The credit appears to be calculated by category or type?

Karen Cate: Thank you, Michael. Yes, this is actually a question that we receive a lot. So I actually, it was in the chat a few times and we've received it multiple times. For those of you who have completed the Form 1116 and Form 1118 in the past, you know that for many years the IRS has required reporting by country even though the person who's asking this question is correct, that the Foreign Tax Credit limitation under Section 904 is computed based on separate categories. Some of those that we mentioned today on the call, including general category and passive category, but the IRS likes to have the information by country as an audit check.

For example, making sure that the Foreign Tax Credits that are claimed, they're consistent with the gross income that is reported for certain countries such that it is a Foreign Tax Credit that is compulsory and should be claimed. So the reason that we ask for country is to make sure that, the taxpayer is complying with the appropriate Foreign Tax Credit rules and claiming the right amount of Foreign Tax Credit.

Michael Smith: Okay, great. All right. Thank you for that explanation. That's makes it very clear. Okay, Karen, I see you tagged a couple questions, so let me go through those with you right away too. This next question reads, if you have a two partner partnership, one individual owns 51% and one LLC 49%, do you have to prepare the K-2 K-3 because one partner is an LLC?

Karen Cate: Thanks, Michael. So, there's several questions, but I actually have questions about this question. One of the questions that I have is, it's not clear if the individual is a non-resident or if that individual is a U.S. citizen or a U.S. resident. If the individual is a non-resident, then it, this partnership does not meet the domestic filing exception. And the partnership would likely need to complete at least Part X of the 1065. If the individual partner is a U.S. citizen, U.S. resident. You are right that the partnership so far has met criterion two. Not sure if it has met the criterion one and three and four that Jim went through.

With respect to an LLC, for Criterion 2 that actually could still meet Criterion 2. An LLC that is a single member LLC that's disregarded for U.S. tax purposes is one of the entities that meets Criterion 2. So, it's not clear based on the question, whether Criterion 2 is met or not, but it is possible.

Michael Smith: Okay. All right. So details are important here. Got it. Okay, thank you. All right, one last question for you here, Karen. So this question reads how do I indicate that I have met the Domestic Filing Exception?

Karen Cate: Thanks. Yes, we have a several conscientious filers out there who ask us this question during the comment period. And yes, you can indicate. In the instructions to the Form 1065 as well as the 1120-S, we have instructions for how you can indicate by an attachment that you have satisfied the domestic filing exception. It's very difficult to get form changes, especially for the existing tax year. So this year please do, if you would like to notify us, notify us by an attachment. Thank you.

Michael Smith: Okay, great. All right, thanks for those, Karen. Going right to our next expert. So Jim, you tag this one. And this question reads, an S Corporation has one shareholder who is a U.S. citizen. The S Corporation has general category foreign source income, but no foreign withholding tax. Is the S Corporation required to complete Schedules K-2 and K-3?

Jim Wu: And thank you for this question. It's a good question and the answer is the, because the S Corporation has general category foreign source income, it would not meet the domestic filing exception, because it, the facts of the question does read as you read that the S Corporation does have foreign source income. So merely considering the domestic filing exception, it would still need to require, it would still need to file this Schedule K-2 and K-3. Now, the S Corporation may be eligible for certain other exceptions to completing these two schedules, K-2, and K-3. For example, if the shareholder does not need to file the Form 1116, the claim of Foreign Tax Credit.

For example, if the shareholder has no foreign source, no foreign source or foreign taxes paid at its own level, individual level. Or the other exception is if the individual taxpayer has less than $300 foreign taxes paid at its individual level or less, $600 or less if it's a joint filer. In that case, the individual taxpayer does not have to complete Form 1116. So those are some other considerations, but because this corporation has foreign source general category income, it does not meet the domestic filing exception. I know I spoke a little bit too much here, but the simple answer is S Corporation has foreign source income, therefore does not meet the domestic filing exception.

Michael Smith: Okay. Okay, good to know. And I'm sure our audience appreciate this too. They want to know your perspective from the IRS about some of these questions and scenarios and they love the example. So definitely feel free to elaborate. No need to simply answer yes or no. We really appreciate that.

All right. Andy, next question is coming your way. Now this question reads, does the Schedule K-2 need to be e-filed or part of XML along with the Form 1065?

Charles “Andy” McManus: Thank you, Michael. That's correct. It does need to be e-filed and it needs to be filed as part of the XML filing. So we are, for the 2020. For the prior tax year, the most recent tax year, we did accept PDF filings, that would have been for 2021. For the 2022 tax year, which would be right now 2023 filing season, we are not accepting PDF attachments. So if you're filing your tax return for the 2022 tax year, we can't accept the PDF attachment. Your software vendors, e-file vendors should not be allowing you to do that. We need an XML and not PDF.

Michael Smith: Okay, good to know. Jim, coming back to you for the next one. This question reads is a Schedule K-2 and K-3 required on a partner that is a partnership in a U.S. Corporation, if they qualify under the domestic filing exceptions? And I believe, can you see that question too, Jim?

Jim Wu: Yes, I can. And if they otherwise qualify under all the four criteria that we went over, except in that case, I believe the fact of the question says that a partner, a partner in this partnership is a U.S. Corporation. Correct.

Michael Smith: Got it. There we go. Right.

Jim Wu: Yes. And therefore that type of partner U.S. Corporation is not one of the partnership partner types that qualifies under this domestic following exception. So, and we discussed that in order for the domestic filing exception to work, our partners must be either U.S. citizens, lawful resident aliens or certain other entities, domestic entities like domestic trust or domestic estates. But unfortunately, C Corporation is not qualifying as a partner for this exception.

Michael Smith: Okay, makes sense, Jim. Okay, Karen, the next question is coming your way. And this question reads, a partnership with solely domestic source income has a foreign partner. What parts of the Schedules K-2 and K-3 must be completed with respect to the foreign partner?

Karen Cate: Thanks, Michael. Foreign partner whether that foreign partner is an individual or a corporation likely would need to, the partnership would need to complete Part X. That part is required for partnerships with the U.S. source income that would be ECI effectively connected income to a foreign partner. So in most cases, it would be the case that if you have a foreign partner, even though you have fully domestic income, you would likely be completing Part X for that partner.

You please check the instructions for the Form 1065 Schedules K-2 and K-3 because you might need to complete other parts, for example, the section Part IX with respect to the base erosion and anti-abuse tax might be relevant with respect to corporate foreign partners. But yes, there may be other sections as well.

Michael Smith: Okay. All right. Thanks for that, Karen. One more for you since I've got you here. Okay, this question reads is Schedule K-2 and K-3 Part II, FTC limitation Section 2 deductions Lines 25 through 54 required to break out deductions by country like the Part II FTC limitation Section 1 gross income section.

Karen Cate: No, there's no place to put the country in that section and it's not required to be reported. The Form 1116 and the 1118 provide instructions for how you are supposed to report deductions.

Michael Smith: Got it. Okay. Thank you for that. Okay, Jim, this next question is yours. This may be a simple question. Is domestic, is the domestic filing exception a year-to-year determination?

Jim Wu: Yes, and the simple answer is yes to that question. And the reason for that is, the circumstances can change from year-to-year, if domestic partnership or S Corporation might have no or a very limited foreign activity in one year, but maybe the next year that same domestic entity might have foreign source income. So, it is a year-by-year determination.

Michael Smith: Okay. Good to know. One more question for you. If the partnership and this question reads, if the partnership otherwise meets the domestic filing exception, but there is one requesting partner, you only need to prepare the Schedule K-2 and K-3 with respect to that requesting partner?

Jim Wu: And yes, that's the simple answer to that question is also yes, and so, the domestic flow-through entity is only required to provide or to prepare Schedule K-2 and K-3 only with respect to that requesting partner, if it otherwise meets the domestic filing exception.

Michael Smith: Okay, all right.

Jim Wu: Even the flow-through entities meets the domestic filing exception, it still has to provide a K-3 to a requesting partner, but only to the partner that makes that request.

Michael Smith: Okay. Understood. All right. All right, thanks Jim. Okay, Karen, we're coming back to you for this next one. This next question reads, what was the site, whereby a U.S. resident is considered a non-resident for sourcing purposes on personal property, for example, 10% or more foreign tax there on?

Karen Cate: Yes, the site for that was code Section 865(g). Also we have a lot of instructions on this in the 1065 Schedule K-2, K-3 instructions for your reference.

Michael Smith: Okay, great. Yes, just one last reminder for the audience. If you haven't done so already, make sure to download today's presentation from the materials drop down arrow. Those are going to be very good references for the future. Okay, Karen, this next question is yours as well. This question reads, where is Part I, Table 1 located?

Karen Cate: Yes, so that question came up a number of times. Again, please reference the instructions to the Form 1065 Schedules K-2 and K-3 and it's also in the Schedule K-2 and K-3 instructions for the 1120-S and the 8865.

Michael Smith: Okay. Okay. Good to know. Thanks. Okay, Karen, one more for you here. This is more of a statement, so I might require elaboration. So this one reads Section 1, how is the individual partner able to specify, specify the source of the income if the partnership issues the Schedule K-2, K-3, this is a bit confusing, and then the question is, can you give an example of foreign sourced partnership versus other income sourced at the partnership level?

Karen Cate: Sure. So, several types of income can be sourced at the partnership level because of the sourcing rules. For example, dividends are sourced based on the residents of the payer in general, and so the partnership would know the residents of the payer of the dividend. Similar for interest, it's sourced based on where the payer's interest is coming from, where it's not clear is the primary example of that is the one that, I covered through the sale of personal property, sale of personal property, the gain on that is generally sourced based on the residency of the seller, and the partnership is not considered the seller.

It's the first non-pass through person that is considered the seller. So in the case of a partnership that's owned by a U.S. individual, it would be a U.S. citizen individual, the residency of the U.S. citizen individual would be what determined that. And in that simple case, the partnership might know that that is the source of the gain, but it could also be reported in column S and you would know that it would be U.S. source, unless there was an exception, with respect to that gain on personal property sale.

Michael Smith: Okay. All right. Thanks for that explanation. Okay, let's move on. Jeff, this question is coming your way and this one is a bit longer too, but I think you have, you are able to see this. So this question reads, even if a partnership or S Corporation has no foreign source income, is it still helpful for a taxpayer to know the taxpayer's share of the entities gross income from all sources so that the taxpayer has good figures on domestic gross income from all entities?

Jeffrey Parry: Yes, that was basically, the subject of our example two, that even though, there's no foreign source income down there, you might need to know the U.S. source income for purposes of allocating expenses that are allocated based on relative gross income numbers. Now, just as like, slight background, like when you're filing your 1116 for each foreign source income category, you're determining your net foreign source income in order to use that as a numerator and determining your Section 904 Foreign Tax Credit limitation. So that involves taking your gross income, figuring out what character it goes to, and then you'd look at all your expenses and all your expenses get allocated and apportioned and the pieces that are allocated to that particular category show up on your 1116 to determine the net income on that category.

And there's a number of, like, we're not going to, I'm not going to go into all the possible methodologies for allocating expenses, but if I just say there will be certain expenses that could be allocated based on relative amounts of foreign and U.S. gross income and in that case you need to know your total U.S. income, which would include your distributed share of the partnership income.

And if you find that you're filling out your 1116 and you have no expenses that you're using this gross income allocation method to apportion them to the different categories, then you probably don't need this information and wouldn't need to. So only if you end up, if you find that you have expenses that you're using a methodology based on relative amounts of gross income to apportion that expense, then you will need that K-3 information. Otherwise, you might not have any of those type of expenses and you won't need to request a K-3 in that case.

Michael Smith: Okay. All right, thanks for that, Jeff. And you are up with the next question. This one reads, this question reads which Forms have K-2, K-3. I guess maybe if you just want to tell us about which forms require Schedules K-2 and K-3?

Jeffrey Parry: Sure, sure Michael. So the Forms are the 1065, the partnership return, the 8865, which is filed by the 8865 filing. And then you have the 1120-S. So you have the 1065 partnership return and the 1120-S return for an S Corp and an 8865, you don't need to file, you don't need to file a K-2, K-3 for like a trust, you would just have for these three returns. So some people ask if, do I need to file for a 1041 trust return? The answer is no. You'd just be for a partnership return of 1065, and 8865 or a 1120-S.

Michael Smith: Okay. Thank you for the clarification. Good answer. All right, one more question for you. Does schedule, and this question reads, does Schedule K-3 replace Schedule K-1?

Jeffrey Parry: Sure. Michael, so, yes. Yes, thank you, Michael. So the answer is no, the Scheduled K-1 remains intact except for the most international, most international tax reporting is no longer reported on the K-1 but rather on the K-3. So you still have to prepare a K-1, you'll still use that information to prepare your tax return of your a partner, but the K-3 will be a supplement or an addition to the K-1 and almost all of your international information reporting is now done on the K-3.

Michael Smith: Okay, perfect. Good to know. Okay. Looks like, all right, one last common one that was highlighted. So a similar version of this must have come up a lot and whoever can answer this best. So this question reads, what if the Schedule K-3 doesn't provide the country code information? How would I know which country to enter on the Form 1116?

Charles “Andy” McManus: This is Andy, I can take.

Michael Smith: Go ahead.

Charles “Andy” McManus: Yes, I'll take a shot at this one. So the answer is, that's a good question. You would need to ask for the information from the past. So you'd go to the partnership, the S Corp and the 8865 return, U.S. return with respect to a foreign partnership. So, you'd go to the domestic return of partnership or to the S Corp and try to get that information and get it from them.

Michael Smith: All right. Perfect. Thanks, Andy. Okay, audience, it looks like that is all the time we have for questions. So Jim, Andy, Karen, Jeff, thank you so much for staying on to share your knowledge and expertise and look through all of these questions. Again, audience, we really, really appreciate getting those questions and being able to answer them live with you. So thank you for participating as well. Now before we close the final session here, Jim, do you have any key points you want the attendees to remember from today's webinar?

Jim Wu: Yes, Michael. I think, there are a few takeaways or key points from this webinar. I think the first one is, if you're claiming or yes, if you're claiming the Foreign Tax Credit on the Form 1116, you're filing the Form 1116, you want to go to Part II and Part III of the Schedule K-2 or K-3 to get the specific information to help you to complete the Form 1116. And then I think the second takeaway is the discussion on a domestic filing exception, and we got a bunch of questions on that.

And please utilize the flow chart in the PowerPoint as a guide to make that determination whether the passthrough entity qualifies for the domestic filing exception. But I do want to add also that, although the flow chart is a very good guide, I would still go to the instructions.

I believe it's in the Schedule K-2 instructions for both the Form 1116, excuse me, for the Form 1065 and 1120S to get more specifics. Because the flow chart, it does not capture all the nuances. So it does provide sort of like a map for this determination. And then finally, and probably most importantly, even if the flow-through entity qualifies for the domestic filing exception, I think it is still wise for the individual partner or for the shareholder to consider their unique tax situation and decide if they should nonetheless request a Schedule K-3, as demonstrated by Jeff today in those two examples, having any additional information from the Schedule K-3 actually increase the Foreign Tax Credit. Back to you, Michael.

Michael Smith: All right, thank you, Jim. And thanks once again to our other presenters. Truly was very informative and I'm sure our audience definitely appreciates it. Well audience, we are planning additional webinars throughout the year. To register for all upcoming webinars, please visit www.irs.gov, perform a keyword search for the term, Webinars, and select the Webinars for Tax Practitioners or Webinars for Small Businesses links.

When appropriate, we will be offering certificates and continuing education credit for upcoming webinars. We invite you to visit our video portal at www.irsvideos.gov. There you can view archived versions of our webinars. Now, please note continuing education credits or certificates of completion are not offered if you view any version of our webinars after the live broadcast. Finally, another big thank you to our speakers, Jim Wu, Charles or Andy McManus, Jeffrey Parry and Karen Cate for their great webinar today and sharing all of their expertise and answering questions with us.

And I also want to thank you, our attendees for attending today's webinar Schedules K-2 and K-3 with a focus on the Foreign Tax Credit for individuals. If you attended today's webinar for at least 100 minutes after the official start time, you qualify for two possible CE credits or continuing education credits. If you stayed on for at least 50 minutes from the official start time, you'll qualify for one possible continuing education credit. If you're eligible for continuing education from the IRS and you registered with your valid PTIN, your credit will be posted in your PTIN account. If you qualify and you have not received your certificate or your credit by March 3rd, then please email us at the address on this screen, cl.sl.web.conference.team@irs.gov.

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