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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.
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.
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:
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.
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:
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.
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.
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