Many business entities are set up as partnerships. Although there are legitimate reasons for some businesses to choose this structure, partnership status may be undesirable for certain activities involving more than one co-owner.
Determining i a Partnership Exists for Tax Purposes
Unsure whether your activity should be classified as a partnership? In 2012, the U.S. Court of Appeals for the Ninth Circuit upheld a 2010 U.S. Tax Court decision that provides guidance on this issue. (William F. Holdner v. Commissioner, 9th Cir., No. 11-71593, October 12, 2012)
In this case, the Tax Court concluded that a profitable farming, ranching and timberland business conducted by a father and son was a 50/50 partnership for tax purposes. In doing so, the court considered the following eight factors:
1. Written or oral agreement of the parties and their conduct in executing its terms.
2. Contributions of money or services by the parties.
3. Control over income and capital and right to take withdrawals.
4. Whether the parties were co-proprietors with mutual obligations to share losses.
5. Whether the venture was conducted in joint names of parties.
6. Whether the parties filed partnership returns or otherwise represented to the IRS or others that they were engaged in a joint venture.
7. Whether separate books were maintained for the venture.
8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the venture.
Keep in mind that this case doesn't set precedent beyond the 9th Circuit. But other circuits deciding similar cases might look to the 9th Circuit's reasoning.
Tax-related reasons to avoid partnership status include:
Tax reporting requirements. Partnerships are required to file annual partnership returns on Form 1065 and issue K-1s to the co-owners. If you can avoid partnership status, each co-owner simply reports the tax results from that person's ownership interest directly on the appropriate form or schedule.
Tax elections. If a partnership exists, certain tax elections must be made at the partnership level (such as the Section 179 election for first-year depreciation). If you can avoid partnership status, co-owners can make tax elections independently at the co-owner level.
Like-kind exchanges. A partnership interest, by definition, is ineligible for tax-deferred like-kind exchange treatment even if the partnership's only asset is real estate. But, if you can avoid partnership status, co-owners can trade fractional real estate ownership interests in like-kind exchanges.
What qualifies as a partnership? For federal income tax purposes, any unincorporated joint venture or other contractual or co-ownership arrangement, in which two or more participants 1) jointly conduct a business or investment activity, and 2) split the income and expenses, will generally be treated as a partnership.
This general rule holds true even when the joint venture or arrangement isn't recognized as a separate entity under applicable state law. Put another way, a partnership can be deemed to exist for federal income tax purposes even when there's no partnership under state law.
There are three arrangements that avoid partnership status for federal income tax purposes:
1. Mere co-ownership, rental and maintenance of real property.
2. A mere agreement to share expenses.
3. When, under certain conditions, the IRS allows taxpayers to "elect out" of partnership status that would otherwise be deemed to exist.
Electing out of partnership tax status is available in the following circumstances:
Jointly owned investment property. Here, the parties must 1) own the investment property in question as co-owners, 2) be able to dispose of their shares independently, and 3) not actively conduct a business. In addition, the co-owners must be able to independently calculate their taxable income from the activity without the necessity of calculating partnership taxable income. This provision is often used to elect out of partnership status for real estate co-ownership arrangements.
Real estate co-ownerships under tenancy-in-common and joint tenancy arrangements often involve "mere co-ownership, rental, and maintenance of real property." This is the first item in the list of arrangements that avoid partnership status (above). Even so, making an affirmative election out of partnership status will remove any doubt about these types of arrangements.
Joint operating agreements. Here, the parties must engage in the joint production, extraction or use of property (such as oil, natural gas, or other minerals). The parties must own the property as co-owners or hold a lease granting exclusive operating rights as co-owners (such as an oil and gas lease).
In addition, the parties must retain the right to separately take in kind their shares of the property produced, extracted or used. They can't jointly sell the property that is produced or extracted except under an arrangement that doesn't extend beyond one year. Finally, each party must be able to independently calculate taxable income from the activity without the necessity of calculating partnership taxable income.
Securities dealers. Dealers in securities can also qualify to elect out of partnership status for short periods in conjunction with joint efforts to underwrite, sell or distribute securities offerings.
Limited liability companies (LLCs) generally can't elect out of partnership status for federal tax purposes. Why? In most states, state law provides that an LLC, not its individual members, owns the LLC's property. Additionally, most state LLC statutes provide that an LLC member can't demand a distribution of property.
The Election Process
There are two ways to elect out of partnership status. The first way is for co-owners to make an affirmative election by the due date, including any extension, of the partnership return that would otherwise be required. This generally means the first year of any activities that create tax consequences for the co-owners. The affirmative election is made by filing a blank partnership tax return form that includes only the name or other identification of the organization, its address and a statement containing certain information required by IRS regulations.
The second way to elect out of partnership status is to show that, based on facts and circumstances, the co-owners always intended to be excluded from Subchapter K of the Internal Revenue Code starting with the arrangement's first tax year.
Important note: The facts-and-circumstances method is not the preferred way to elect out of partnership tax status. That method is a relief provision intended for co-owners that fail to affirmatively elect out using the blank Form 1065 method. The IRS may be reluctant to accept elections made under the facts-and-circumstances method.
If you fail to file a partnership return when it's required, steep penalties may apply. For tax years beginning in 2017, the monthly penalty for failing to file a partnership return or failing to provide required information is $200 per partner. The penalty can be assessed for a maximum of 12 months.
For example, the maximum penalty for failing to file a calendar-year 2017 Form 1065 for an unincorporated two-person business that must be treated as a partnership would be $4,800 (2 x $200 x 12 = $4,800).
The IRS provides a limited exemption from the failure-to-file penalty, however. This exemption is available to domestic partnerships with 10 or fewer partners — but only when all the partners have reported their proportionate shares of income and deductions on timely filed tax returns.
Deciding when a partnership exists for federal income tax purposes can be tricky. Your tax advisor can help you determine whether you have a partnership and can handle any extra tax filings that may be necessary.