Partnership Status For Tax Purposes.

Ronald Smith and his son, Paul, had a fairly substantial agricultural operation in Miami.  They chose to report their accounting arrangement as separate businesses instead of as a Partnership Status For Tax Purposes.  All income and expenses were reported on one tax return or the other.  The thing that probably bothered the IRS more than anything else was that although the income was divided 50/50, the expenses were disproportionately allocated to Ronald.  Ronald, and accountant, had significant income from his accounting service, while day to day operation of the farm was handled by Paul.  In order to avoid being whipsawed the IRS took a rather draconian approach in its notice of deficiency. It taxed each of them on 100% of the income and denied all the deductions.  Over the three years in question, the operation produced about $80,000 in taxable income, which had been reported.  The deficiency notices totaled over $1,000,000 in tax.

The ultimate decision by the Tax Court was that the arrangement was a Partnership Status For Tax Purposes and, lacking anything better to go on, net income should have been divided 50/50, which presumably was the result the IRS was aiming for when it issued the overblown deficiency notices.  The Ninth Circuit just upheld the Tax Court decision.  The Ninth Circuit decision does not include much detail and I would have glossed over it had I not written about the Tax Court decision, which tells a rather fascinating story.  Some Tax Court decisions are more interesting than most novels.

There is an important practice point in this case.  Mr. Smith created a lot of trouble for himself by treating his arrangement with his son as two separate businesses instead of a Partnership Status For Tax Purposes. I have a hard time seeing what he was gaining.  Assuming the expense allocation was reflective of how they would ultimately split the money, the bottom line effect that it had could have been achieved with a well-drafted partnership agreement.  Instead, he ended up with a nightmare.  I look at it as a cautionary tale.

Partnership For Tax Purposes?

When two or more people ally in profit-making activities, they might account for those activities as separate businesses and, if individuals, report them on Schedule C or page 1 of Schedule E.  Alternatively, they might file a partnership return.  In that case, an extra return is filed (i.e. Form 1065) and K-1s are issued to the partners.  Each partner reports a share of the partnership taxable income on page 2 of Schedule E.  Despite what many people think, this is not something that is a matter of free choice, except in special circumstances.  In principle, a accountant should analyze the arrangement between the parties and determine whether or not the arrangement is a partnership for income tax purposes (What the individuals call the arrangement is only one of the factors to consider and probably not one of the more important ones).  The problem is that in applying accounting and tax laws to facts on this question you will find a fairly large gray area, particularly when you are dealing with people who do business on a handshake (or maybe a wink and a nod).  Fuzzy law applied to fuzzy facts makes for lots of fuzz.

Why Should Anybody Care?

Imagine a parent, probably a father, who puts the cheerios in front of the little kid and pours in the orange juice.  The little kid already upset about several other deviations from the smooth running household machine that temporarily absent Mom maintains will likely complain.  The answer to the complaint is something that is genetically implanted in the mind of male parents.  “It’s all going to the same place anyway.  Eat it.”  You could look at the separate businesses versus partnership issue the same way.  It all ends up in the accounting of the adjusted gross income of the individuals, so why worry about it?

It does make a difference.  Even though a partnership does not pay tax, it is a “taxpayer”.  It has its own accounting method and a variety of determinations are made at the partnership level.  An interest in a partnership, unlike a co-ownership interest in an asset, such as real estate, cannot be the subject of a like-kind exchange.  If you think you had a couple of separate businesses and it turns out that you really had a partnership you can end up with a pretty ugly mess, which is what happened to the Smiths.

When In Doubt Accountant Should File As Partnership?

If you have an arrangement that might be viewed as a partnership, the safer course is probably to get a partnership agreement drafted or more likely form an LLC and have an operating agreement drafted.  Then file as a partnership.  It is a complex area but the tip-off to your arrangement being a partnership is that you are carrying on business and dividing profits. If the arrangement is substantial and there are compelling business or tax reasons to avoid partnership status you will probably need even more complicated agreements.  Ironically the best person to draft them for you is probably a tax attorney who is an expert on partnerships.