Inadvertent partnerships.

The existence, or nonexistence, of a partnership is not always easy to determine. Clients enter into informal arrangements and written "agreements" that can create partnerships without their knowledge. The Code allows for electing out of partnership treatment in certain situations and some agreements attempt to opt out of partnership treatment by specifically stating that they do not create a partnership. The existence of a partnership can make a substantial difference in how a client is taxed, as demonstrated by the following scenarios.

Case 1

Assume several taxpayers enter into a "participation agreement" under which they agree to contribute funds to a gold refiner who assigns them a "participating interest" in a contract to purchase and refine gold ore concentrate. The taxpayers are entitled to receive a certain percentage of the refined gold. Although the participation agreement is similar to a standard partnership agreement, it specifically states that it is not a partnership and that "the participants expressly elect to be excluded from the application of Subchapter K, Chapter 1, Subtitle A pursuant to the provisions of Sec. 761(a)(2)." Assume further that the gold refiner goes bankrupt and no partnership return is ever filed. The taxpayers lose their investment and deduct it on their tax returns as an ordinary loss. On audit, the IRS might disallow the deduction. The Service might take the position that the investment was either a loan or the purchase of a capital asset that became worthless, thus creating a capital loss. If the taxpayers were partners with the gold refiner, their loss could be characterized either as an ordinary loss from partnership operations or a Sec. 165 ordinary loss from the abandonment of a worthless partnership interest. (Assume Sec. 752 is not a problem since there were no partnership liabilities; see Echols, 5th Cir., 1991.) Will the written agreement not be treated as a partnership control?

Sec. 761 can be used by unincorporated organizations that are "availed of ... for the joint production, extraction, or use of property . . . ." However, a valid election under Sec. 761 is not made in an agreement between the parties involved. An organization must file Form 1065, U.S. Partnership Return of Income, for the first tax year for which it wishes to be excluded, complete with the information required by Regs. Sec. 1.761-2(b)(2)(i). Since no return had been filed, there was no election out of subchapter K, but was there a partnership in the first place?

Regs. Sec. 1.761-1 defines the term "partnership" as "a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate within the meaning of the Code. The term partnership' is broader in scope than the common law meaning of partnership, and may include groups not commonly called partnerships." The Uniform Partnership Act states: "A partnership is an association of two or more persons to carry on as co-owners a business for profit." Hence, a partner is an "owner" of a business. He does not simply share expenses or have only a profits interest. In the scenario presented, the taxpayers were assigned a portion of the gold refining contract; hence, they were co-owners. They definitely wanted to make a profit on the refining of the ore. All the elements of a partnership are present. But does the parties' stated intent not to create a partnership control?

Substance controls over form. As the Supreme Court has stated, "the Court has looked to the objective realities of a transaction, rather than to the particular form the parties employed. The Court has never regarded |the simple expedient of drawing up of papers' . . . as controlling for tax purposes when the objective economic realities are to the contrary ... Nor is the parties' desire to achieve a particular tax result necessarily relevant." (Frank Lyon Co., 435 US 561 (1978).) Thus, despite the language in the participation agreement, a strong case can be made that the taxpayers were in a partnership and were entitled to a Sec. 165 ordinary loss.

Case 2

Assume a taxpayer had entered into an arrangement with a real estate broker under which the broker was to find property suitable for subdividing and resale, the taxpayer advanced the money to purchase the property, and the broker did all the work necessary to subdivide and sell the property to home builders. In return for doing all of the work, the broker received half the profits from the sale of the lots. The agreement between the taxpayer and the broker was entitled "Letter of Agreement" and consisted of one page. Since the lots were sold on an installment basis, the issue arose as to whether or not to make a Sec. 453A election. Without a timely filed Sec. 453A election, a dealer is not eligible for installment sale treatment on residential lots. However, a nondealer may sell lots on the installment basis and take capital gains treatment on the profits. Also, a dealer in lots would have self-employment income and a corresponding self-employment tax liability. Since the taxpayer was simply a "money man" who played no part in the choosing, subdividing or selling of the lots, may he take the position that he was a passive investor and not a "dealer" of real property?

This exact situation occurred in Williams, DC Tex., 1983. The district court agreed that the "money man" was not personally a "dealer." However, the court concluded that although no formal partnership existed, there was really a de facto partnership with one active partner and one passive partner. Investment intent and the character of gain are determined at the partnership level. (See Barham, et al., 301 F Supp 43 (DC Ga. 1969), aff'd, 429 F2d 40 (1970).) Consequently, the partnership was a dealer, and ordinary income resulted from the sale of the lots. Since the taxpayer was not a limited partner (limited partnerships come into existence when there is a good faith attempt to comply with the filing requirements of a state's Uniform Limited Partnership Act), he would receive income subject to self-employment tax (Cokes, 91 TC 222 (1988)).

The taxpayer could have avoided self-employment tax by simply forming a limited partnership and being a limited partner. He could have taken almost all of the potential gain at capital gains rates, and avoided the restrictions on dealer installment sales reporting, by making one bulk installment sale of the land to a controlled corporation. (One bulk sale of land would not create dealer status.) The corporation then could subdivide and sell the lots on an installment basis and use the sales proceeds to pay its installment obligation to the taxpayer.

Conclusion

The $50 a month per partner penalty for failure to file a partnership return is usually the least of a taxpayer's worries in an unintended partnership situation. Most elections have to be made on a timely filed partnership return. Failure to note the existence of a partnership can eliminate valuable options in the tax treatment of sales and exchanges and the allocation of income or loss. Practitioners should review a draft of any "agreements" their clients enter into, no matter how short or informal; this could save them from unintended (and costly) consequences.