Lessons from Tax Court: Brothers Should Have Filed a Partnership Tax Return
For federal income tax purposes, an unincorporated joint venture (or other arrangement under which several participants conduct a business or investment activity and split the income and expenses) is generally treated as a partnership. This general rule applies even if the arrangement isn’t 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 if no partnership exists for state-law purposes.
The complex rules can be confusing for taxpayers. Here’s the story about when joint activities must be treated as partnerships for federal income tax purposes. We’ll also explain the details of one U.S. Tax Court decision on the issue.
According to the Internal Revenue Code, arrangements between several taxpayers that must be classified as partnerships for federal income tax purposes 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 says that mere co-ownership, rental, and maintenance of real property doesn’t create a partnership for federal income tax purposes. Similarly, mere agreements to share expenses don’t create partnerships for federal tax purposes.
Avoiding Partnership Tax Status
When possible, avoiding classification as a partnership for federal income tax purposes is often a desirable goal. Here are three reasons why.
1. Simplified Tax Filing
When no partnership is deemed to exist for tax purposes, there is no requirement to file an annual partnership return on Form 1065. There’s also:
- No requirement to issue an annual Schedule K-1 to each co-owner.
- No requirement to follow the often-complicated partnership taxation rules.
Instead, each co-owner simply reports the tax results from that co-owner’s 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 percentage share of the tax numbers on Schedule E of Form 1040.
2. Flexibility Regarding Tax Elections
If no partnership exists for tax purposes, each co-owner can independently make (or not make) applicable tax elections — such as the election to claim Section 179 first-year depreciation deductions. It doesn’t 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 the partners must live with the consequences.
3. Eligibility for Like-Kind Exchanges
When no partnership is deemed to exist for tax purposes, co-owners of real estate can trade their fractional ownership interests in tax-deferred Section 1031 like-kind exchanges. In contrast, taxpayers aren’t allowed to make Section 1031 exchanges of partnership ownership interests — even when the partnership’s only asset is real estate.
Tax Court Case: Brothers Conducted Businesses as a Partnership
In the facts underlying one Tax Court decision, two brothers agreed to share the work, as well as the income and expenses, from two side businesses in which they were both involved. The taxpayer in this case was one of the brothers, and he also had a regular job as an engineer. The two activities in question were an event-promotion business and a car-export business.
Although the brothers had no formal partnership agreement, they agreed to divide the tasks necessary to conduct the activities and split the income and expenses. Although many of the business documents referred to his brother and not him, the taxpayer explained that this was because his brother was the “front man for the businesses even though they considered themselves equal partners.” Therefore, the taxpayer considered the businesses to be a partnership for tax purposes.
The taxpayer apparently reported some but not all of his share of the revenue from the businesses and his purported share of deductible expenses on Schedule C, “Profit or Loss from Business,” of his Form 1040. No partnership return was filed. After an audit, the IRS disallowed the expenses, and the taxpayer took his case to court.
What Was the Intention?
The court noted that whether parties have formed a partnership is a question of fact. While all circumstances should be considered, the most important issue is whether the parties intended to, and did in fact, join together to conduct a business or investment venture. It isn’t necessary for partners to have a formal agreement for a partnership to exist for federal income tax purposes. The court concluded that the brothers did indeed intend to join together to conduct the event-promotion business and the car-export business. Therefore, the businesses constituted a partnership for federal income tax purposes.
The court opined that the IRS had properly disallowed the taxpayer’s claimed deductions on several grounds:
First, they should have been reported on a partnership return.
Second, the taxpayer failed to demonstrate that all the expenses were actually for deductible items and that he had not been reimbursed by his brother for some of them.
Third, the taxpayer failed to demonstrate that he had sufficient tax basis in his partnership interest to deduct the expenses, because there was no evidence of how much he had contributed to the partnership or taken out of the partnership as distributions.
Finally, the taxpayer’s credibility was further eroded when failed to explain to the IRS that he and his brother had a partnership until the case went to trial.
Therefore, the taxpayer was liable for an income tax deficiency and an 20% accuracy-related penalty due to negligence or disregard of the rules or a substantial tax underpayment. (Nwabasili, TC Memo 2016-220)
Whenever you start a business or investment venture, check in with your tax advisor. This is especially important when other people or businesses will be involved. Without sound advice, you may run afoul of tax rules you never even knew about and pay an expensive price that could have been avoided.