How to Determine if a Partnership Exists?

If you’re involved in a business or investment venture with one or more co-owners, you may have an unintended partnership for federal income tax purposes. Here’s what you need to know about this potentially troublesome issue.

General Rule

Under a general federal tax rule, a partnership exists when several taxpayers conduct a business or investment activity as an unincorporated joint venture (or other contractual or co-ownership arrangement) and agree to split the income and expenses. This is the case even when the joint venture or arrangement isn’t recognized as a separate entity under applicable state law. Put another way, a partnership can exist for federal income tax purposes even when there’s no partnership under state law.

Arrangements that can be deemed to be partnerships for federal income tax purposes include:

• Joint ventures,
• Syndicates,
• Groups, and
• Pools.

The same treatment also applies to any other unincorporated organization or arrangement through which any business, financial operation or venture is carried on and which isn’t treated for federal income tax purposes as a corporation, trust or estate.

Under this general rule, unsuspecting taxpayers can easily have an unintended partnership for federal income tax purposes. However, mere co-ownership, rental and maintenance of real property doesn’t create a partnership for federal income tax purposes. Similarly, a mere agreement to share expenses doesn’t create a partnership for federal income tax purposes.

One instructive U.S. Tax Court decision highlights eight factors to help you determine whether a venture will be deemed a partnership.

Tax Court Provides Partnership Guidance

It’s not always easy to determine if a partnership exists for federal income tax purposes. A well-reasoned 2010 U.S. Tax Court decision sheds light on the question. The U.S. Court of Appeals for the Ninth Circuit upheld this decision in 2012.

In Holdner v. Commissioner (T.C. Memo. 2010-175), the Tax Court sided with the IRS. The court concluded that a profitable farming, ranching and timberland business conducted in Oregon by a father and son was a 50/50 partnership for federal income tax purposes. Therefore, the court disallowed the father’s attempt to claim over 50% of the venture’s deductible expenses on his personal returns for the tax years in question. The father was assessed back taxes and interest plus the 20% substantial understatement penalty on the underpaid taxes.

In concluding that a partnership existed, the court evaluated the following eight factors:

1. Agreement of the parties and their conduct in executing its terms,
2. Contributions by the parties,
3. Control over income and capital and the right to take withdrawals,
4. Whether the parties had obligations to share losses,
5. Whether the venture was conducted in the joint names of the parties or some other name,
6. Whether the parties represented to third parties that they were operating as a partnership,
7. Whether separate books were maintained for the venture, and
8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the venture.

No single factor is conclusive. However, if more than half the factors indicate partnership status, it may be more difficult to claim that an activity isn’t a partnership.

Adverse Consequences of Unintended Partnerships

Why might it be undesirable for a venture to be classified as a partnership for federal income tax purposes? Partnerships have specific reporting requirements under federal tax law. A partnership must file an annual Form 1065 and provide a Schedule K-1 to each partner. That’s because partnerships are pass-through entities, meaning the partnership’s income, losses, deductions and credits flow through to the partners, who must report them on their tax returns. Co-owners that didn’t intend to operate as a partnership may face unexpected filing obligations and penalties for noncompliance.

For partnership tax returns due in 2024, the penalty for failing to file a partnership federal income tax return or failing to provide required information on a partnership return is $245 per partner per month. The penalty can be assessed for a maximum of 12 months. For example, the maximum penalty for failing to file a calendar-year 2024 Form 1065, which is due in 2025, for an unincorporated two-person business that must be treated as a partnership would be $5,880 ($245 times 2 times 12). It may be prudent to file partnership returns in borderline situations to avoid this penalty.

There’s a limited exemption from the failure-to-file penalty. The exemption is available only to domestic partnerships with 10 or fewer partners when all the partners have reported their proportionate shares of income and deductions on timely filed returns. The exemption isn’t available when income or deductions aren’t allocated proportionately.

Electing Out of Partnership Status

A potential option to avoid this troublesome issue is to make an election out of the partnership provisions under Subchapter K of the Internal Revenue Code. Electing out of partnership tax status is available to owners of arrangements that would otherwise be classified as partnerships for tax purposes in these circumstances:

Jointly owned investment property. To qualify under the provision, the parties must 1) own the investment property in question as co-owners, 2) be able to dispose of their respective ownership shares independently, and 3) not actively conduct a business. The parties must be able to independently calculate their taxable income from the activity without calculating partnership taxable income. For example, if the parties elect out of partnership status, they can’t make special (disproportionate) tax allocations of income and deductions.

Joint operating agreements. To qualify under this provision, the parties must engage in the joint production, extraction or use of property (such as oil, natural gas or other minerals). The parties must own the property as co-owners or hold a lease granting exclusive operating rights as co-owners (such as an oil and gas lease). In addition, they must retain the right to separately take in-kind their shares of the property produced, extracted or used. Finally, each party must be able to independently calculate taxable income from the activity without calculating partnership taxable income.

Securities dealers. Dealers in securities can qualify for the election out for short periods in conjunction with joint efforts to underwrite, sell or distribute securities offerings.

Important: The election-out privilege is often unavailable to operations conducted through limited liability companies (LLCs). Why? Because most state LLC statutes provide that the LLC owns the LLC’s assets, as opposed to the LLC’s members indirectly owning the LLC’s assets. Additionally, most state LLC statutes provide that an LLC member can’t demand a distribution of LLC property.

There are two ways to elect out of partnership status. First, co-owners can make an affirmative election by the due date, including any extension, for the partnership return for the first year the election is desired. This is generally the first year of activities that create tax consequences for the co-owners. The affirmative election out is made by filing a blank partnership return that simply provides the organization’s name or other identification, its address, and a statement containing certain other required information.

The second way to elect out of partnership status is to show that, based on facts and circumstances, the co-owners always intended to be excluded from the partnership provisions of the tax code. However, relying on this method isn’t the preferred way of electing out. It’s intended to be a relief provision for co-owners that fail to elect out affirmatively — and the IRS may be reluctant to accept these “backdoor” elections.

Advantages of Avoiding Partnership Status

Electing out of partnership status is often desirable for at least three reasons:

1. When partnership status is avoided, the partnership doesn’t need to file an annual Form 1065 or issue K-1s to the co-owners. Instead, the co-owners each report the tax results from their interest directly on the appropriate IRS form or schedule. For example, an individual co-owner of a rental real estate venture would report the tax results on Schedule E of his or her personal tax return.

2. Co-owners can independently decide whether to make tax elections, such as the Section 179 first-year depreciation election, at the co-owner level.

3. Co-owners can trade fractional real estate ownership interests in tax-deferred Section 1031 like-kind exchanges. In contrast, a partnership interest is ineligible for Sec. 1031 treatment, even if its only asset is real estate.

What’s Right for Your Situation?

Determining whether a partnership exists for federal income tax purposes can be tricky. Consult your tax advisor for help making an informed decision and filing any necessary partnership returns.

Copyright 2025

This article appeared in Walz Group’s March 10, 2025 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.