What Constitutes a Partnership for Tax Purposes?

Craig W. Smalley, EA
Founder/CEO
CWSEAPA PLLC
Columnist
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A partnership is a business entity with two or more owners who “carry on a trade, business, financial operation, or venture and divide the profits therefrom.” It also is a conduit that passes through to each partner his share of the partnership's income and deductions.

The partners, not the partnership, are taxed on the partnership's income. The partnership only files Form 1065 showing each partner's distributive share of the partnership income, deductions, gains, and losses. Each partner includes his share of these items on their own returns. A partnership can be formed with individuals or entities. 

The United Stated Tax Court, in Luna v. Commissioner, provided eight factors to consider in determining the existence of a partnership for tax purposes:

  • The agreement of the parties and their conduct in executing its terms
  • The contributions, if any, which each party has made to the venture
  • The parties' control over income and capital and the right of each to make withdrawals
  • 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
  • Whether business was conducted in the joint names of the parties
  • Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were joint ventures
  • Whether separate books of account were maintained for the venture
  • Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise

The interesting part of a partnership is when spouses go into business for themselves. They can be treated as a partnership, or a sole-proprietorship, depending on certain factors. The Tax Court in White v. Commissioner,  ruled that the taxpayers, husband and wife, who had a loose business arrangement with another couple, failed to prove the existence of a partnership under the criteria established by the court's oft-cited Luna v. Commissioner case.

Alternatively, the court concluded that even if a partnership existed, it lacked reliable evidence of the partnership's total receipts to support an allocation of income different from the amounts determined by the IRS's bank deposits analysis.

Mr. Marc White was approached by his ex-wife, April Van Patten, about forming a mortgage company and, along with their respective spouses, Kelly White and Mr. Van Patten, agreed to work together in the real estate business in 2010 or 2011.

This business had two separate components under separate names: Mortgage Lending Services of California was the mortgage lending business and Homebuyers Resource Center was the real estate transaction business. The couples did not reduce the terms of their business relationship to writing.

The couples ran their business informally and did not consult any tax professionals. For a time, they employed a bookkeeper who used QuickBooks to maintain the company's books, but those files were not accessible and the taxpayers did not call the bookkeeper to testify at trial.

During 2011, the taxpayers withdrew funds from Mr. White's retirement account to support the new business, but the Van Pattens did not make similar financial contributions.

Mr. White oversaw office operations and Mrs. White, a real estate agent, handled the other agents, monitored leads and house showings and wrote offers. Mrs. Van Patten served as the broker of record and Mr. Van Patten oversaw marketing, structuring loans and loan processing.

The taxpayers initially used their personal checking account for the business' banking since the Van Pattens could not open business bank accounts. Later, business checking and savings accounts were opened listing the signatories as Mr. White as president, Mrs. White as treasurer and Camille Straughn as secretary. Other business accounts were designated as sole proprietorships with Mr. White as the sole signatory and sole proprietor.

The taxpayers controlled the business's funds and used business accounts to pay personal expenses and personal accounts to pay business expenses, but did not keep records of these payments. They also used business funds to pay the Van Pattens' personal expenses, including mortgage payments for Van Pattens’ residence, which was in Mr. White's name.

The court was tasked with the determination on whether the couples' business was properly classified as a partnership for tax purposes. If the business was a partnership, the taxpayers would be taxable on only their distributive shares of the partnership's income.

Ultimately, considering the entire record and applying the Luna factors, the court concluded that the business was not properly classified as a partnership for tax purposes. While the record indicated that there was some sort of relationship, it did not support a conclusion that the business was a partnership.

The court analyzed the Luna factors and found that all but one factor supported a finding that a partnership did not exist. To begin with, the parties must comply with a partnership agreement's terms, even if it is oral and informal. Here, Mr. White acknowledged that the couples did not divide the business's profits equally, despite orally agreeing to do so.

The taxpayers withdrew varying sums from the business, while the Van Pattens received irregular payments in different amounts from the taxpayers. The court also could not count the taxpayers' mortgage payments on the Van Pattens’ residence as evidence of the Van Pattens’ right to partnership profits since the taxpayers deducted the interest on their own joint Forms 1040.

Also, the Van Pattens could have received income from sources other than their share of the business income. Further, the taxpayers did not explain how payments shown in the Van Pattens’ tax reporting got into the business bank accounts. This factor weighed against a finding that a partnership did in fact exist.

About Craig W. Smalley, EA

Craig Smalley

Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.

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