Thursday, July 12, 2018
A partnership is an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, § 6. Similarly, the regulations state that a business arrangement “may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” 26 C.F.R. §301.7701-1(a)(2). If there is a written partnership agreement, that usually settles the question of whether the arrangement is a partnership. Unfortunately, relatively few farm or ranch partnerships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
Sometimes an interesting tax or other legal issue arises as to whether a particular organization is, in fact, a partnership. For example, sometimes taxpayers attempt to prove (or disprove) the existence of a partnership in order to split income and expense among several taxpayers in a more favorable manner (see, e.g., Holdner, et al. v. Comr., 483 Fed. Appx. 383 (9th Cir. 2012), aff’g., T.C. Memo. 2010-175) or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful.
When is a partnership formed and why does it matter? That’s the topic of today post.
The Problems Of An Oral Arrangement
Because a partnership is an agreement between two or more individuals to carry on as co-owners a business for profit, a partnership generally exists when there is a sharing of net income and losses. See, e.g., In re Estate of Humphreys, No. E2009-00114-COA-R3-CV, 2009 Tenn. App. LEXIS 716 (Tenn. Ct. App. Oct. 28, 2009). The issue can often arise with oral farm leases. A crop-share lease shares gross income, but not net income because the tenant still has some unique deductions that are handled differently than the landlord's. For example, the landlord typically bears all of the expense for building maintenance and repair, but the tenant bears all the expense for machinery and labor. Thus, there is not a sharing of net income and the typical crop-share lease is, therefore, not a partnership. Likewise, a livestock share lease is usually not a partnership because both the landlord and the tenant will have unique expenses. But, if a livestock share lease or a crop-share lease exists for some time and the landlord and tenant start pulling out an increased amount of expenses and deducting them before dividing the remaining income, then the arrangement will move ever closer to partnership status. When the arrangement arrives at the point where there is a sharing of net income, a partnership exists. With a general partnership comes unlimited liability. Because of the fear of unlimited liability, landlords like to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
For federal tax purposes, the courts consider numerous factors to determine whether a particular business arrangement is a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) the contributions, if any, which each party has made to the venture; (3) the parties’ control over income and capital and the right of each to make withdrawals; (4) whether each party was a principal and coproprietor sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (5) whether business was conducted in the joint names of the parties; (6) whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that there were joint venturers; (7) whether separate books of account were maintained for the venture; and (8) whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise. See, e.g., Luna v. Comr., 42 T.C. 1067 (1964). While of the circumstances of a particular arrangement or to be considered, the primary question “is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.” Id. If a business arrangement is properly classified as a partnership for tax purposes, a partner is taxed only on the partner’s distributive share of the partnership’s income.
White v. Comr., T.C. Memo. 2018-102, involved the issue of whether an informal arrangement created a partnership for tax purposes. The petitioners, a married couple, joined forces with another couple to form a real estate business. They did not reduce the terms of their business relationship to writing. In 2011, one of two years under audit, the petitioners contributed over $200,000 to the business. The other couple didn’t contribute anything. The petitioners used their personal checking account for business banking during the initial months of the business. Later, business accounts were opened that inconsistently listed the type of entity the account was for and different officers listed for the business. The couples had different responsibilities in the business and, the business was operated very informally concerning financial activities. The petitioners controlled the business funds and also used business accounts to pay their personal expenses. They also used personal accounts to pay business expenses. No books or records were maintained to track the payments, and the petitioners also used business funds to pay personal expenses of the other couple. The petitioners acknowledged at trial that they did not agree to an equal division of business profits. When the petitioners’ financial situation became dire and they blurred the lines between business and personal accounts even further. Ultimately the business venture failed and the other couple agreed to buy the petitioners’ business interests.
Both couples reported business income on Schedule C for the tax years at issue. They didn’t file a partnership return – Form 1065. The returns were self-prepared and because the petitioners did not maintain books and records to substantiate the correctness of the income reported on the return, the IRS was authorized to reconstruct the petitioners’ income in any manner that clearly reflected income. The IRS did so using the “specific-item method.”
The petitioners claimed that their business with the other couple was a partnership for tax purposes and, as a result, the petitioners were taxable on only their distributive share of the partnership income. The court went through the eight factors for the existence of a partnership for tax purposes, and concluded the following: 1) there was no written agreement and no equal division of profits; 2) the petitioners were the only ones that capitalized the business – the other couple made no capital contributions, but did contribute services; 3) the petitioners had sole financial control of the business; 4) the evidence didn’t establish that the other couples’ role in the business was anything other than that of an independent contractor; 5) business bank accounts were all in the petitioners’ names – the other couple was not listed on any of the accounts; 6) a partnership return was never filed, and the petitioners characterized transfers from the other couple to the business as “loan repayments;” 7) no separate books and records were maintained; 8) the business was not conducted in the couples’ joint names, and there was not “mutual control” or “mutual responsibility” concerning the “partnership” business. Consequently, the court determined that the petitioners had unreported Schedule C gross receipts. They weren’t able to establish that they should be taxed only on their distributive share of partnership income.
The case is a reminder of what it takes to be treated as a partnership for tax purposes. In additions to tax, however, is the general partnership feature of unlimited liability, with liability being joint and several among partners. How you hold yourself out to the public is an important aspect of this. Do you refer to yourself as a “partner”? Do you have a partnership bank account? Does the farm pickup truck say “ABC Farm Partnership” on the side? If you don’t want to be determined to have partnership status, don’t do those things. If you want partnership tax treatment, bring your conduct within the eight factors – or execute a written partnership agreement and stick to it.