One of the thorniest tasks to confront a tax adviser may be having to determine whether the business or investment relationship between two taxpayers constitutes a partnership for tax purposes.
Where the persons involved have formed a limited liability company or a limited partnership under state law, they have formed a tax law partnership[i]; the fact that they did not intend to do so, or were motivated solely by the limited liability protection afforded by such a legal entity, is irrelevant.[ii]
In the absence of such a legal entity, however, the analysis can be challenging.
For example, in a typical “drop and swap,” a partnership may distribute a tenancy-in-common interest in real property to one of its members in liquidation of their partnership interest to enable such member to effect a like kind exchange with their share of the proceeds from the sale of the property, while the partnership and the remaining members dispose of their “collective” TIC interest for cash in a taxable sale. It is often difficult to conclude that the TIC ownership arrangement resulting from the distribution is distinguishable, for tax purposes, from the partnership that preceded it.[iii]
Although the TIC owner in the foregoing example sought to avoid partnership status with their former partners, it is sometimes the case that a taxpayer will try to establish partnership status for tax purposes so as to shift income – and the resulting tax liability[iv] – to another, as illustrated by the decision described below.
The Start of Something Wonderful?
Taxpayer and Friend agreed to work together in the real estate business. They did not reduce the terms of their business relationship to writing.[v]
Taxpayer withdrew cash from his retirement account, which he used to support the new business. Friend was unable to, and did not make, a similar financial contribution to the business.
Taxpayer’s personal checking account was used for the business’s banking during the first few months of operation. Friend had explained to Taxpayer that he had a history with bad checks in a prior business and could not open business bank accounts.
Bank accounts were later opened that were identified as business accounts. In one such account, the legal designation of the business was described as “corporation.” Taxpayer was the authorized signatory for the business accounts. In another, Taxpayer was listed as the sole signatory, and the business designation selected for the account was “Sole Proprietorship,” with Taxpayer identified as the sole proprietor.
The business was run very informally, though Taxpayer and Friend had different roles and responsibilities with respect to the business. As alluded to above, Taxpayer controlled the business’s funds, and used them to pay business expenses; and if Friend incurred a business-related expense, Taxpayer would reimburse him. But Taxpayer often used the business accounts to pay personal expenses, including personal expenses for Friend. Taxpayer also used his personal accounts to pay business expenses, and did not maintain books and records tracking these payments.
While Taxpayer argued that he and Friend had agreed to an equal division of profits, Taxpayer acknowledged at trial that this did not occur. The record showed irregular cash withdrawals by Taxpayer and some payments to Friend, along with commission payments and “draws” to other individuals. These cash withdrawals exceeded the documented payments made to, or on behalf of, Friend.
As the financial situation of the business deteriorated, the lines between business accounts and Taxpayer’s personal accounts became even more blurred.
The business ultimately failed. Taxpayer and Friend agreed to part ways, and Friend agreed to buy Taxpayer’s interests in the business.
Income Tax Returns
No Form 1065, U.S. Return of Partnership Income, was ever filed for the business.
Taxpayer and Friend each filed Forms 1040, U.S. Individual Income Tax Return, for the tax years at issue.
Both Taxpayer and Friend reported business income and expenses on Schedule C, Net Profit from Business, of their respective personal income tax returns for the years at issue. For example, Friend reported income for his “real estate” activities on his Schedules C, and his “Wage and Income Transcript” for these years indicated that he was issued Forms 1099-MISC, Miscellaneous Income, related to his real estate activities, though the gross receipts Friend reported on the Schedules C exceeded the total gross receipts reported to Friend on the Forms 1099-MISC. Taxpayer never explained how the payments reported to Friend were transferred to the business.
In the process of examining Taxpayer’s tax returns and bank records, the IRS identified certain transfers to Taxpayer’s bank account and subsequently summoned bank records from this account.
The IRS conducted a bank deposits analysis to compute Taxpayer’s income but was unable to complete it given the incomplete bank account records received. As a result, the IRS used the specific-item method for the years at issue to reconstruct Taxpayer’s income.[vi] The IRS determined and classified deposit sources from the descriptions of deposited items on Taxpayer’s account records.
Based on its analysis, the IRS determined that Taxpayer had unreported Schedule C gross receipts for the years at issue.
Taxpayer did not argue that the gross receipts computed by the IRS were from nontaxable sources. Instead, Taxpayer asserted that the gross receipts were the revenue of a partnership and should have been split between Taxpayer and Friend as partners.
Taxpayer further argued that because the business profits should have been split, the gross receipts Taxpayer reported on his returns were overstated and should be adjusted downward to account for the amounts attributable to Friend.
Thus, the issue before the Tax Court was whether Taxpayer’s and Friend’s business relationship constituted a partnership during the tax years at issue.
Existence of Partnership?
If the business was properly classified as a partnership for tax purposes, Taxpayer would have been taxable on only his distributive share of the partnership’s income.
The Court explained that Federal tax law controls the classification of “partners” and “partnerships” for Federal tax purposes. A partnership, it stated, is an unincorporated business entity with two or more owners.[vii]
Whether taxpayers have formed a partnership – a type of “business entity” that is recognized for tax purposes – is a question of fact, and while all the circumstances are to be considered, “the hallmark of a partnership is that the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” Thus, the “essential question” was whether Taxpayer and Friend intended to, and did in fact, join together for the conduct of such an enterprise.
In determining whether a partnership existed, the Court considered a number of factors, each of which is addressed below.[viii]
Agreement of Parties and Conduct in Executing Terms
Petitioners and Friend did not reduce the terms of their agreement to writing. A partnership agreement may be entirely oral and informal, but the parties must demonstrate that they complied with its terms.
While they may have agreed orally to an equal division of profits, Taxpayer acknowledged that this division did not occur. Taxpayer withdrew varying sums of money from the business at irregular intervals. Friend could not withdraw money directly but instead received irregular payments in amounts different from the withdrawals and payments by Taxpayer.
Taxpayer pointed out that Friend’s returns already reported his share of the business income. Taxpayer, however, never established that the Friend did not receive income from other sources.
Moreover, Taxpayer never explained how the payments reported on Friend’s Forms 1040 made their way into the business bank accounts or were accounted for otherwise.
Parties’ Contributions to Venture
Taxpayer withdrew funds from his retirement account and used them to capitalize the business, but there was no credible evidence that Friend made any capital contributions.
However, the record also suggested that Taxpayer and Friend each performed services related to the business.
Therefore, the Court weighed this factor as favorable toward finding a partnership.
Control Over Income and Right To Make Withdrawals
Taxpayer argued that Friend had equal rights to withdraw funds from the accounts, but the credible evidence before the Court indicated that Taxpayer had sole financial control. Taxpayer was the signatory on all of the business accounts throughout the business’s existence; Friend never was.
While the record showed that Taxpayer made payments to or on behalf of Friend, no evidence showed that Friend had rights to withdraw funds from the accounts aside from the fact that Taxpayer and Friend had debit cards; but the account statements did not indicate who made the withdrawals, nor did Taxpayer tie any specific expenditures to Friend.
While Friend received some payments related to the business, and Taxpayer made certain payments on behalf of Friend, this evidence was not enough for the Court to conclude that Friend had joint control over the business’s income.
Co-Owner or Non-partner Relationship
The IRS asserted that Friend had a separate business and was an independent contractor to whom Taxpayer paid commissions. Taxpayer asserted that Friend’s compensation was contingent on the proceeds from the business and there were no fixed salaries.
The record indicated that Friend played a role in the business, but the evidence was not sufficient to show that this role was as a co-owner, rather than as an independent contractor. Business owners, for example, may agree to compensate key employees with a percentage of business income, or brokers may be retained to sell property for a commission based on the net or gross sale price. Although these arrangements may result in a division of profits, neither constitutes a partnership unless the parties become co-owners.
The only evidence that Friend received payments more akin to a partner’s share than an independent contractor’s commission or draw was Taxpayer’s uncorroborated testimony, which the Court did not find credible.
Whether Business Was Conducted in Joint Names
As the business’s bank records reflected, the accounts were held in Taxpayer’s name and included the name of the business. Friend was not listed on any of the accounts. Further, Taxpayer designated the business as either a sole proprietorship or a corporation, not as a partnership.
This suggested that the parties both treated “the real estate business” as their own sole proprietorships – not as a joint enterprise – not just on their Forms 1040, but also to financial institutions (and potentially to check recipients).
Filing of Partnership Returns or Representation of Joint Venture
Taxpayer did not prepare and file a Form 1065 for the business for the taxable years at issue. Instead, Taxpayer and Friend each reported the income and expenses on their respective Schedules C.
Taxpayer asserted that the parties represented to others that they were joint venturers. The Court rejected Taxpayer’s uncorroborated testimony, stating that it could not overcome the parties’ reporting of income and expenses on their returns and the bank account records in evidence.
Maintenance of Separate Books and Accounts
Taxpayer contended that he maintained separate books and records at the entity level. However, Taxpayer failed to produce any evidence that separate books and accounts were maintained other than his uncorroborated testimony. The business bank accounts were held in Taxpayer’s name. Taxpayer also admitted that he used business accounts for personal expenses and personal accounts for business expenses.
This factor, therefore, weighed against finding that a partnership existed.
Exercise of Mutual Control and Assumption of Mutual Responsibilities
Taxpayer and Friend testified that they each assumed separate roles in the real estate activities, and the record supported a finding that they had a business relationship in which they had different roles.
But the fact that they may have performed separate functions did not convince the Court that the parties exercised the “mutual control” and shared the “mutual responsibilities” indicative of a partnership.
Considering the record as a whole, and applying the foregoing factors, the Court concluded that the business was not properly classified as a partnership between Taxpayer and Friend for tax purposes.
While the record indicated that Taxpayer and Friend had some sort of business relationship, the record did not support a conclusion that the business was a partnership.
Therefore, the Court held that Taxpayer had unreported Schedule C gross receipts.
Any facts-and-circumstances-based determination can be tricky. The existence or non-existence of a partnership for tax purposes in the absence of a business entity created under state law (such as an LLC) is no exception, and an adviser must be careful of not allowing the result that they or their client desires that to influence their conclusion.
A joint venture or other contractual 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. For example, a separate entity exists for tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent.
However, a joint undertaking merely to share expenses does not create a separate entity for tax purposes. Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes.
Nevertheless, if this co-ownership arrangement is placed into a multi-member LLC, for example, or if a Form 1065 is filed on its behalf, then the arrangement will be treated as a tax partnership and the owners will be hard-pressed to disregard the form they have “chosen.”
The point is that one should not find oneself in a “facts-and-circumstances” situation with the resulting uncertainty; nor should the participants in an investment activity inadvertently create a partnership with the complexity that it entails. With proper planning and documentation, the participants in a business or investment venture should know exactly how their economic relationship with one another and the business will be treated for tax purposes.
[i] The partnership will cease to be treated as such when it: has only one member (thereby becoming a sole proprietorship), has checked the box to be treated as an association taxable as a corporation, incorporates under state law, or ceases to engage in any activity and liquidates.
[ii] Many real estate investors fall into this situation, and they often regret it subsequently, when the property is to be sold and one of them wants to engage in a like kind exchange while the other wants cash.
[iii] This explains, in no small part, the presence of IRC Sec. 761 which affords certain co-owners the ability to elect out of partnership status. It is also why the IRS issued Rev. Proc. 2002-22 and its 15 factors to consider in determining whether a TIC co-ownership arrangement constitutes a partnership for purposes of the like kind exchange rules.
[v] Of course, they didn’t. Our posts abound with instances in which a well-drafted agreement would have saved everyone involved from the exorbitant costs of litigation.
[vi] The specific-item method is a method of income reconstruction that consists of evidence of specific amounts of income received by a taxpayer and not reported on the taxpayer’s return.
A taxpayer is responsible for maintaining adequate books and records sufficient to establish the amount of his income. If a taxpayer fails to maintain and produce the required books and records, the IRS may determine the taxpayer’s income by any method that clearly reflects income. The IRS’s reconstruction of income “need only be reasonable in light of all surrounding facts and circumstances.”
[vii] Reg. Sec. 1.761-1, 301.7701-1, 301.7701-2 and 301.7701-3.
[viii] The Court considered the following factors:
(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 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;
(5) Whether business was conducted in the joint names of the parties;
(6) Whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they 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.