What is the purpose of Schedules K-2 and K-3?
The schedules were designed to give the IRS more detailed information about the foreign transactions of partnerships. They are an expansion of the Foreign Transactions section of Schedule K (page 4) of Form 1065.
Why are these forms generated?
In 2021, the IRS introduced Schedules K-2 and K-3 to Form 1065 used by partnerships. These schedules report foreign income earned by the partnership in the tax year, and are in excess of 20 pages in length for Schedules K-2 and 20 pages for each partner's K-3. However, the reporting required by most investment clubs involved only a few fields on these schedules.
For 2022, the IRS allows partnerships to opt out of Schedules K-2 and K-3 if four conditions are fully met (https://www.irs.gov/instructions/i1065s23):
If a club meets the above criteria, a club administrator may use the notification system in the club's myICLUB.com website to notify members of its intent to not file Schedules K-2 and K-3. This tool is available in the Taxes tab of the club's website.
If a member does request a Schedule K-3 (for instance, if they have a significant amount of foreign income to report on their personal return), then the myICLUB.com Club Tax Printer can generate a K-3 for that partner only as well as the Schedule K-2 for the club return.
How do we know if one of our securities is a foreign investment?
The Internal Revenue Service defines a foreign company as any company that is not a US company; generally this is determined by its country of incorporation. The country of incorporation may not always be the same as the location of its headquarters, or the country in which it primarily operates. You can find the country of incorporation in some the company’s SEC or other regulatory filings, or directly from the company via its investor relations website. While you may find similar information from other sources, the company itself, and the SEC filings are the most reliable source of information.
Do not assume the country of incorporation for any security that your club owns. For instance, many “Chinese” companies are not actually incorporated in China.
American Depository Receipts (ADRs) and American Depository Shares (ADSs) are shares of non-U.S. companies that trade on U.S. exchanges, and are considered foreign companies.
The portion of distributions made by a mutual fund or exchange traded fund (ETF) that holds foreign securities must also be reported.
How do we mark a security as foreign?
Sign in to your club, and go to Accounting > Securities > Update security settings. Click the Pencil button next to the security name. On the next page, use the Country drop-down, to select the country of incorporation. Click Submit to save the changes.
If you have already performed the Allocation of Income and Expenses for the tax year, make sure to do that again after changing the Country of a Security, then the taxes can be regenerated.
What if we choose the wrong country, list a foreign security as a U.S. one, or a U.S. security as foreign?
At least for now (07/1/2023), nothing. Our reading of the IRS documentation is that they will be lenient in enforcement regarding the new schedules for the time being.
Who gets which forms?
The Schedule K-2 is included with the Form 1065 filed with the IRS if the club did not or could not opt-out of filing the forms.
The Schedule K-3 is treated like the Schedule K-1, for partners that require it, or if the club does not or can not opt-out of filing the forms. If only specific members of the club require the K-3, then only they need to be provied copies; selections can be made in the tax printer, if specific members of the club require a K-3 when the club would otherwise entirely opt out of producing the forms.
Why is most of my Schedule K-2 and/or K-3 blank?
This is normal. Both the Schedule K-2 and K-3 are designed to cover a wide range of possibilities and will be largely blank even for membes that might require them. Only Parts II and III will have any values for typical investment clubs, while Parts I and Parts IV to XIII will be blank. Schedules generated by myICLUB.com will typically include details of the information reported in Parts II and III on separately-attached Supplements.
Why does the Supplement for Part III not list the name of the company, just a two letter code?
This is normal. Part III is only concerned with which country the money came from.
Why does the “Type of Tax” column in the Part III Supplement just say WHTD?
WHTD is the IRS’s code for “Withholding Tax on Dividends,” and is a reference to money that was withheld (taxed) by a foreign government.