For federal income tax purposes, an unincorporated joint venture or 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.
This general rule applies even if the joint venture or arrangement is not recognized as a separate legal entity (apart from its owners) under applicable state law.
In other words, a partnership can exist for federal income tax purposes even though no partnership exists for state-law purposes.
On the other hand, under certain circumstances, taxpayers can “elect out” of partnership status when a partnership would otherwise be deemed to exist for federal income tax purposes.
Confusing? You bet.
Here are the rules concerning when joint activities must be treated as partnerships for federal income tax purposes and when partnership tax status is not required.
Basic Considerations in Partnership Determination
According to the Internal Revenue Code, some arrangements between several taxpayers must be classified as partnerships for tax purposes. These include syndicates, groups, pools, joint ventures, 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, the IRS and the courts have stated that mere co-ownership, rental, and maintenance of real property does not create a partnership for federal income tax purposes. Similarly, mere agreements to share expenses do not create partnerships for federal income tax purposes.
In addition, 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.
When possible, avoiding classification as a partnership for federal income tax purposes is often a worthy goal. Here are three reasons why.
- Simplified Tax Filing. When no partnership exists for tax purposes, there is no requirement to file an annual partnership return on Form 1065, or issue an annual Schedule K-1 to each co-owner. It is also not necessary to follow the complicated partnership taxation rules. Instead, each co-owner simply reports the tax results from his or her percentage share directly on the appropriate form or schedule. For example, an individual co-owner of a rental real estate property would report his or her share of the tax numbers on Schedule E of Form 1040.
- Flexibility Regarding Tax Elections. If no partnership is deemed to exist for tax purposes, each co-owner can independently make (or not make) applicable tax elections (such as the election to claim the Section 179 first-year depreciation deduction). It does not matter what the other co-owners do. In contrast, when a partnership exists, some tax elections must be made (or not made) at the partnership level, and all the partners must live with the consequences.
- Eligibility for Like-Kind Exchanges. If a partnership does not exist for tax purposes, co-owners of real estate can trade their fractional ownership interests in tax-deferred like-kind exchanges under Internal Revenue Code Section 1031. In contrast, taxpayers are not allowed to make Section 1031 exchanges of partnership ownership interests — even when the partnership’s only asset is real estate.
It can be difficult to decide if partnership tax status is required. 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. Obviously, however, when many factors indicate partnership tax status, 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”
For some arrangements that would otherwise be classified as partnerships for federal tax purposes, the co-owners can “elect out” of partnership tax status.
The election out option is available in the following limited circumstances:
- 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.
- 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.
- Securities Dealers can elect out of partnership tax status for short-term joint efforts to underwrite, sell, or distribute securities.
Beware: The option to elect out may be unavailable for joint operations conducted via LLCs because some state LLC laws stipulate that the entity (as opposed to its members) is the owner of the LLC’s property. 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
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. Because the penalty can quickly get expensive, it dictates in favor of filing partnership returns in borderline situations.
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.