Let’s talk about partnerships, and what constitutes as one for tax purposes.
According to the IRS, a partnership is when two or more owners “carry on a trade, business, financial operation, or venture and divide the profits therefrom”, while all income and deductions pass through to the partners. Under this description, a partnership can be formed by both entities or individuals.
For each tax period, the business owners are to be taxed on the partnership’s income, while the partnership itself must file under Form 1065 to show each partner’s income share, deductions, losses, and gains. Additionally, the business owners should report these on their tax returns as well.
At first glance, this loose terminology of what constitutes as a partnership can be confusing. For instance, what happens when a married couple decides to go into business together? Would they then qualify as a partnership or a sole proprietor?
To help clear the air, in case Luna v. Commissioner, the United States Tax Court lays out eight defining factors on what makes a partnership:
- 1) All parties involved agree on business decisions and to become a partnership;
- 2) Any contributions made by partners go towards the business only;
- 3) Each partner has control over the business’ income and capital, and maintains the right to withdraw money at any time;
- 4) Each partner – whether principle or co-proprietor – must share in both the net profits and losses;
- 5) All business is conducted in the joint names of all parties involved;
- 6) All partners file their returns as a federal partnership, or provide additional legal representation as a collective enterprise;
- 7) Separate accounts and bookkeeping are done for the partnership; and
- 8) All parties have a mutual share over profits, losses, responsibilities, and control of the business.
If all points are met, then the business is considered a partnership and should be taxed accordingly.
If you are planning on forming a partnership, be sure to make sure all processes are set up properly. And create an operating agreement that spells out how disputes will be handled as well as any other scenarios that would affect the operations of the partnership. Doing it when the partnership begins can save a lot of headaches and misunderstandings later.
