For federal income tax purposes, an unincorporated joint venture, other contractual, or co-ownership arrangement, under which several participants conduct a business or investment activity and split the profits, is generally treated as a partnership.
If the joint venture or arrangement is not recognized as a separate legal entity (apart from its owners) under applicable state law, this general rule still applies. A partnership can exist for federal income tax purposes even though no partnership exists for state-law purposes.
However, taxpayers can “elect out” of partnership status when a partnership would otherwise be deemed to exist for federal income tax purposes, under certain circumstances.
Confused yet? Yes!
Here are the rules regarding when partnership tax status is not required, and when joint activities must be treated as partnerships for federal income tax purposes.
Basic Considerations in Partnership Determination
Some arrangements between several taxpayers must be classified as partnerships for tax purposes, according to the Internal Revenue Code. These include groups, joint ventures, pools, syndicates, and other unincorporated organizations through which any business, financial operation, or venture is carried on and which is not classified for federal income tax purposes as a corporation, trust, or estate.
However, it should be noted that mere co-ownership, rental, and maintenance of real property does not create a partnership for federal income tax purposes, as stated by the IRS and the courts. Also, mere agreements to share expenses do not create partnerships either.
When certain conditions are met, the IRS allows taxpayers to “elect out” of partnership status for federal income tax purposes when partnership status would otherwise be required.
Deciding if partnership tax status is required can be difficult. To determine partnership status, the U.S. Tax Court has looked at issues such as:
- The parties’ agreement to perform specific tasks;
- Contributions of capital;
- Control over bank accounts;
- Whether the venture is conducted in the joint names of the parties
- Who claims tax deductions?
- How financial records are kept; and
- Whether partnership tax returns are filed and how the operation is represented to state tax authorities, insurance companies and others.
None of these factors is conclusive by itself. When many factors indicate partnership tax status, however, it becomes hard to argue that a joint activity is not required to be treated as a partnership for federal income tax purposes.
In Limited Circumstances, Co-Owners Can “Elect Out”
Co-owners can “elect out” of partnership tax status for some arrangements that would otherwise be classified as partnerships for federal tax purposes.
This option is available in the following limited circumstances:
- Joint Operating Agreement. To qualify, the parties to the joint operating agreement must jointly produce, extract, or use property, such as oil, natural gas, or other minerals. The parties must be co-owners of the property or hold a lease that grants them exclusive operating rights, such as an oil and gas lease. In addition, the parties must retain the right to separately take their shares of the property in kind. They cannot jointly sell the property except under an arrangement that does not extend beyond one year. Finally, each party must be able to independently calculate taxable income from the activity. Additional requirements apply to natural gas production joint operating agreements.
- Jointly Owned Investment Property. To qualify for this exception, the property co-owners must be able to dispose of their shares independently, and they must not conduct an active business (such as a hotel operation). In addition, the co-owners must be able to independently calculate their taxable income. This exception is often used to elect out of partnership tax status for real estate co-ownership.
- Securities Dealers can elect out of partnership tax status for short-term joint efforts to underwrite, sell, or distribute securities.
Beware: Some state LLC laws stipulate that the entity (as opposed to its members) is the owner of the LLC’s property, and the option to elect out may be unavailable for joint operations conducted via LLCs. Also, some state LLC laws stipulate that members cannot demand distributions of their shares of the entity’s property.
Penalty for Not Filing Required Returns Can Be Costly
In borderline situations it is best to file partnership returns, because the current penalty for failing to file a partnership federal income tax return (on Form 1065) when one is required is $195 per partner per month. The penalty can be assessed for up to 12 months, and can quickly become expensive.
Key Point: The IRS provides a limited exemption (under IRS Revenue Procedure 84-35) from the failure-to-file penalty for domestic partnerships with 10 or fewer partners when all the partners have reported their proportionate shares of income and deductions on timely filed returns. When income or deductions are not allocated proportionately, the exemption is unavailable.
For more information about partnership status in your situation, consult with Filler & Associates, or your current tax adviser.