Intro to Corporate Taxes:

Rules on Partnerships

A partnership is a business arrangement whereby the partners share in the capital and services provided, plus they share the profits that result from their partnership. According to the IRS, "an unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits." A partnership where all the partners do is invest money and then expect profits to come out isn’t really a partnership. In the eyes of the IRS, you not only have to invest the money, but also perform the services that you are offering through this partnership.

The rules governing the creation of a partnership changed in 1996. Any partnerships before 1997 don’t have to adhere to these changes only if they have at least two partners and they don’t elect to fill out the form 8832 to become a corporation.

There are some organizations that can’t become partnerships according to the IRS. They are the following:

  • An organization formed under a federal or state law that refers to it as a corporation, body corporate, or body politic.
  • An organization formed under a state law that refers to it as a joint stock company or joint stock association.
  • An Insurance Company.
  • Certain Banks.
  • An organization wholly owned by a state or local government.
  • An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships).
  • Certain foreign organizations.
  • A tax-exempt organization.
  • Real estate investments trust.
  • An organization classified as a trust under section 301.7701-4 of the regulations or otherwise subject to special treatment under the Internal Revenue Code.
  • Any other organization that elects to be classified as a corporation by filing Form 8832.

A partnership agreement that is simple to follow and understand should be established by every organization with two or more partners and it should include the original agreement and any modifications that have been made. The IRS asks that all partners must agree to all modifications and adopt them in any other manner provided by the partnership agreement. The agreement or modifications can be oral or written.

The rules for partnerships among family member (spouses, ancestors, and lineal descendants [or a trust for the primary benefit of those persons]) are a little different. They have to meet one of the following two conditions as outlined by Uncle Sam:

  • The capital is a material income-producing factor. This means that most of the money made by the business is due to the investment of this capital. This capital can also be the money used to run the operations at a business that requires inventories or investments in a plant, machinery, or equipment. The family member acquired their capital interest in a transaction with another family member, who either sold it to them or gifted it to them. They own the partnership interest. They control the interest.
  • The capital is not a material income-producing factor. Meaning income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. They have come together to form a business based on good faith. They decide that their contributions entitle them to shares in the profits and they will both provide some capital plus services for the business.

A good example to consider for the first condition is a grocery store. Joe, the owner of the store, decides to give his son Mike 50% of the business. The profit from the business is $50,000. Joe is the one who performs the services, and they are estimated to be around $20,000. Mike doesn’t perform any services. Come tax time, the IRS is only going to look at $30,000 worth of profits. The services performed by Joe cut into the profit and the leave the remaining partnership profit at $30,000. The money is split right down the middle and Mike ends up with $15,000. Because he didn’t share the services, they went 100% to his father.

Husband/wife partnerships also have their own rules. Husband/wife partnerships can survive without partnership agreements as long as they have an understanding about the profits and losses. Each spouse has to file a form 1065, not a schedule C for form 1040. Each has to carry over their share of the profits and the losses to the form 1065 and attach to there joint or separate form 1040. They also have to file a separate form for self-employment taxes if they are self-employed, schedule SE with form 1040.