Business operators form partnerships for a variety of reasons from raising funds, to widening the pool of knowledge and skills beyond a single owner. Under the Treasury Regulations, a partnership exists for tax purposes when two or more owners carry on a trade, business, financial operation or venture and divide the profits therefrom. Isn’t this simple and clear? Not always. Whether taxpayers are really conducting themselves within the above definition, can be a question effecting the amount of income each taxpayer should be reporting on their tax return.
Such a question was addressed in a recent case, White, et ux., TC Memo 2018-102. The taxpayer’s books were disorganized, and the IRS determined their business income by analyzing bank account deposits. Based on that analysis the IRS asserted that the taxpayers had under reported their income. The taxpayer disagreed, citing that they had a partnership and should only report their distributive share of the partnership’s income. I.e. some of the income the IRS calculated would be attributable to the other partner.
Federal income tax rules treat a partnership as a “flow through entity,” which means the partnership doesn’t pay income tax itself but rather flows through the income to the partners who then consider the income on their tax returns. We call the allocation of income that flows through to each of the partners their distributive share, which is usually determined by partnership agreement.
The Court agreed with the IRS ruling that taxpayers, husband and wife, who had a loose business arrangement with another couple, failed to prove the existence of a partnership.
The courts use a set of eight factors, from the 1964, “Luna Case” to determine a partnership’s existence for tax purposes.
1. The agreement and execution of its terms
2. The contributions each party made to the venture
3. The parties’ control over income, capital and distribution
4. Whether the parties shared net profits and losses
5. Whether business conducted in the joint names of parties
6. Whether the parties filed partnership tax return
7. Whether books and records were maintained for the venture
8. Whether the parties exercised mutual responsibilities
There were a number of curious facts about the operation of this venture, which demonstrated the lack of conventional administration. In summary, the court found that the taxpayers only met one of these eight factors. Mr. White had withdrawn funds from his retirement accounts to start the business, which was considered a capital contribution. The court also notes that even if they were to agree that a partnership existed, there were no reliable records of the partnership’s income or an agreed upon allocation among the parties.
If you are intending to be in a partnership structure with income being allocated among partners and taxed accordingly, make sure to execute a formal agreement between partners, establish bank accounts for the partnership to conduct business, keep books records at the partnership level and file the appropriate tax filings for a partnership. These are some of the things that will help address the above list of factors that will be used to evaluate if you truly have a partnership for tax purposes.