Sunday, September 5, 2021
The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. Uniform Partnership Act, §6. As an estate planning device, the partnership is generally conceded to be less complex and less costly to organize and maintain than a corporation. A general partnership is comprised of two or more partners. There is no such thing as a one-person partnership, but there is no maximum number of partners that can be members of any particular general partnership.
Sometimes interesting legal issues arise as to whether a particular organization is, in fact, a partnership. 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 business relationships are based upon a written partnership agreement or, as it is expressed in some cases, a set of articles of partnership.
When does a partnership exist – it’s the topic of today’s post.
Informality Creates Questions
If there is no written partnership agreement, one of the questions that may arise is whether a landlord/tenant lease arrangement constitutes a partnership. Unfortunately, the great bulk of farm partnerships are oral. 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). This also tracks the U.S. Supreme Court’s definition of a partnership as the sharing of income and gains from the conduct of a business between two or more persons. Comr. v. Culbertson, 337 U.S. 733(1949). This rule has been loosely codified in I.R.C. §761, which also includes a “joint venture” in the definition of a partnership.
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 deductions. 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.
This means that a partnership can exist in certain situations based on the parties’ conduct rather than intent. Does the form of property ownership constitute a partnership? By itself, the answer is generally “no.” See, e.g., Kan. Stat. Ann. §56a-202. Thus, forms of ownership of property (including joint ownership) do not by themselves establish a partnership “even if the co-owners share profits made by the use of the property.” See, e.g., Kan. Stat. Ann. §56a-202(c)(1). Also, if a share of business income is receive in payment of rent, a presumption that the parties would otherwise be in a partnership does not apply. See, e.g., Kan. Stat. Ann. §56a-202(c)(3)(iii).
Tax Code, Tax Court and IRS Views
The United States Tax Court, in Luna v. Comr., 42 T.C. 1067 (1964) set forth eight factors to consider in determining the existence of a partnership for tax purposes. In Luna, the Tax Court considered whether the parties in a business relationship had informally entered into a partnership under the tax Code, allowing them to claim that a payment to one party was intended to buy a partnership interest. To determine whether the parties formed an informal partnership for tax purposes, the Tax Court asked "whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise." The Tax Court listed non-exclusive factors to determine whether the intent necessary to establish a partnership exists.
The eight factors set forth in Luna are:
- The agreement of the parties and their conduct in executing its terms;
- The contributions, if any, which each party has made to the venture;
- The parties' control over income and capital and the right of each to make withdrawals;
- Whether each party was a principal and co-proprietor, 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;
- Whether business was conducted in the joint names of the parties;
- Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint ventures;
- Whether separate books of account were maintained for the venture;
- Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise
A recent Tax Court case is instructive on the application of the Luna factors. In White v. Comr., T.C. Memo. 2018-102, the petitioner was approached by his ex-wife, about forming a mortgage company and, along with their respective spouses, they orally agreed to work together in the real estate business in 2010 or 2011. The business was conducted informally, and no tax professionals were consulted. In 2011, the petitioner withdrew funds from his retirement account to support the business. The ex-wife and her new husband did not make similar financial contributions. Each of the “partners” handled various aspects of the business. The petitioner initially used his personal checking account for the business, until business accounts could be opened. Some accounts listed the petitioner as “president” and his wife as treasurer, but other business accounts were designated as “sole proprietorship” with the petitioner’s name on the account. The petitioner controlled the business funds and used business accounts to pay personal expenses and personal accounts to pay business expenses. Records were not kept of the payments. Business funds were also used to pay the ex-wife’s personal expenses.
The Tax Court applied the Luna factors and concluded that the business was not a partnership for tax purposes. The Tax Court determined that all but one of the Luna factors supported a finding that a partnership did not exist. To begin with, the parties must comply with a partnership. There was no equal division of profits; the parties withdrew varying sums from the business; the petitioner claimed personal deductions for business payments; the ex-wife and her new spouse could have received income from sources other than their share of the business income; and there was no explanation for how payments shown on the ex-wife’s return ended up being deposited into the business bank account.
Alternatively, the court concluded that even if a partnership existed, there was no reliable evidence of the partnership's total receipts to support an allocation of income different from the amounts that the IRS had determined by its bank deposits analysis.
When applying the Luna factors to typical farming/ranching arrangements, it is relevant to ask the following:
- Was Form 1065 filed for any of the years at issue (it is required for either a partnership or a joint venture)?
- Did the parties commingle personal and business funds?
- Were any partnership bank accounts established?
- Was there and distinct treatment of income and expense between business and personal expenses?
- How do the parties refer to themselves to the public?
- How do the parties represent themselves to the Farm Service Agency?
- Are the business assets co-owned?
An informal farming arrangement can also be dangerous from an income tax perspective. Often
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 or establish separate ownership of interests for estate tax purposes. However, such a strategy is not always successful, as demonstrated in the following case. See, e.g., Speelman v. Comr., 41 T.C.M. 1085 (1981).
Liability and other Legal Concerns
Why all of the concern about whether an informal farming arrangement could be construed legally as a partnership? Usually, it is the fear of unlimited liability. Partners are jointly and severally liable for the debts of the partnership that arose out of partnership business. It is this fear of unlimited liability that causes parties that have given thought to their business relationship to have written into crop-share and livestock-share leases a provision specifying that the arrangement is not to be construed as a partnership.
The scenarios are many in which legal issues arise over the question of whether a partnership exists and gives rise to some sort of legal issue. For example, in Farmers Grain Co., Inc. v. Irving 401 N.W.2d 596 (Iowa Ct. App. 1986), the plaintiff extended credit to the defendant who was a tenant under an oral livestock share lease. Upon default of the loan, the defendant filed bankruptcy and the plaintiff tried to bind the landlord to the debt under a partnership theory. The court held that a partnership had not been formed where the landlord did not participate in the operation, no joint bank accounts were established, and gross returns were shared rather than net profits.
In Tarnavsky v. Tarnavsky, 147 F.3d 674 (8th Cir. 1998), the court determined that a partnership did exist where the farming operation was conducted for a profit, the evidence established that the parties involved intended to be partners and business assets were co-owned.
Oral business arrangements can also create unanticipated problems if one of the parties involved in the business dies. In In re Estate of Palmer, 218 Mont. 285, 708 P.2d 242 (1985), the court determined that a partnership existed even though title to the real estate and the farm bank account were in joint tenancy. As such, the surviving spouse of the deceased “partner” was entitled to one-half of the farm assets instead of the land and bank account passing to the surviving joint tenant.
Formality in business relationships can go along way to avoiding legal issues and costly court proceedings when expectations don’t work out as anticipated. Putting agreements in writing by professional legal counsel often outweighs the cost of not doing so.