In a significant and welcome update for small partnerships, the IRS has expanded the domestic filing exception for Schedules K-2 and K-3 for tax year 2025. These schedules, originally introduced to improve international tax compliance and transparency, placed a heavy compliance burden on partnerships, even those with entirely domestic operations and partners. The new expanded exception offers administrative relief to qualifying partnerships that meet specific requirements, thereby simplifying their tax filing obligations.
What Are Schedules K-2 and K-3?
Schedules K-2 and K-3 were introduced in 2021 to replace parts of the former Form 1065 Schedule K and K-1 international tax sections. Their primary purpose is to provide standardized reporting for items of international tax relevance, such as foreign taxes paid, foreign-sourced income, and international partners’ information.
While they have improved clarity for the IRS and foreign partners, these schedules quickly became a compliance challenge, especially for smaller partnerships with no foreign income or foreign partners. The expanded exception aims to address this issue for tax year 2025 filings.
What Is the Small-Partnership Domestic Exception?
The original domestic exception, introduced in 2022, allowed certain partnerships to skip filing Schedules K-2 and K-3 if all partners were U.S. persons and the partnership had no foreign activity or international tax relevance. However, the rules were somewhat ambiguous and inconsistently applied.
In response, the IRS issued expanded guidance in 2024 (effective for tax year 2025), refining and broadening the domestic exception criteria to ease the compliance burden on small, domestic-only partnerships.
Who Qualifies for the Expanded Domestic Filing Exception?
To qualify for the expanded domestic exception for Schedules K-2 and K-3 in tax year 2025, a partnership must meet all of the following criteria:
- All partners must be U.S. persons for the entire tax year. This includes U.S. citizens, resident aliens, domestic corporations, domestic trusts, and domestic partnerships.
- No foreign income, assets, or taxes must be involved. The partnership must have no items of international tax relevance, such as foreign-sourced income, foreign taxes paid, or ownership in foreign entities.
- No knowledge of partner-level foreign reporting requirements. If the partnership has not received notification or indication from any partner regarding the need for foreign tax information, it can presume the exception applies.
- Timely Notification to Partners: The partnership must provide notice to partners that no Schedules K-3 will be provided unless requested. This notification must be sent no later than two months before the due date (without extension) of the partnership return. For calendar-year filers, this means by January 15, 2026.
- No Schedule K-3 requests by the 1-month rule: If no partner requests a Schedule K-3 by one month before the return due date (i.e., by February 15, 2026, for calendar-year filers), the partnership may rely on the exception.
Why This Matters for Small Partnerships
Small partnerships with simple, domestic operations were previously required to spend significant time and money completing schedules that had no relevance to their actual tax situations. This expanded exception alleviates much of that burden by allowing eligible partnerships to avoid unnecessary international disclosures, thereby:
- Reducing compliance costs and administrative work
- Streamlining tax preparation processes
- Avoiding confusion and misreporting errors
- Preserving resources for businesses without international complexity
This is especially valuable for local professional firms, real estate partnerships, and family-owned businesses operating strictly within the United States.
How to Notify Partners
The IRS requires partnerships relying on the exception to notify their partners that Schedules K-3 will not be issued unless requested. This notification must:
- Be in written form (email or physical letter)
- Include a clear statement that the partnership does not anticipate providing Schedule K-3 unless it is requested
- Be provided by January 15, 2026 (for calendar-year filers)
Failure to provide this notification on time will disqualify the partnership from using the exception, even if it otherwise meets all other criteria.
What Happens If a Partner Requests a Schedule K-3?
Under the “one-month rule,” if any partner requests a Schedule K-3 by February 15, 2026 (for calendar-year filers), the partnership must prepare and provide the K-3 to that partner. In this case, the partnership must also file both Schedules K-2 and K-3 with the IRS as part of its Form 1065 return.
If no such request is received by the deadline, the partnership is fully exempt from filing or preparing either schedule for that year.
Key Takeaways and Best Practices
- Review your partner list early in the tax year to confirm all partners are U.S. persons.
- Evaluate your partnership’s operations to ensure there is no international income, taxes, or investments.
- Document and maintain proof of timely partner notifications.
- Monitor partner communication channels in case a Schedule K-3 is requested before the one-month deadline.
- Consult a tax professional to ensure you meet all IRS requirements for using the expanded exception.
Potential Pitfalls to Avoid
While the expanded exception is helpful, there are risks if a partnership assumes it qualifies without meeting all conditions. Common mistakes include:
- Missing the January 15 notification deadline
- Failing to recognize indirect foreign income sources (e.g., through another passthrough entity)
- Assuming that all LLC members are U.S. persons without verification
- Ignoring or overlooking a partner’s request for Schedule K-3
Any of these errors can lead to IRS penalties for noncompliance or delays in return processing.
Conclusion
The expanded small-partnership domestic exception for Schedules K-2 and K-3 reporting is a significant step toward simplifying tax compliance for U.S.-based partnerships with no foreign ties. By meeting the clear and manageable conditions laid out by the IRS, partnerships can eliminate unnecessary reporting burdens while staying fully compliant.
Partnerships should act early to determine their eligibility, provide timely partner notifications, and monitor for any Schedule K-3 requests. When used properly, this exception can save time, money, and stress during the tax filing season.
