Taxing Lessons From Court Decisions

Decisions — Parsing the partnership

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Forming a partnership takes two—or maybe eight.

In T.C. Memo. 2018-102 (White), the question was whether the taxpayer’s business constituted a partnership for tax purposes.

The taxpayer and his spouse agreed to work together with another couple in the real estate business in late 2010 or early 2011. The business had two separate components under two separate names. One part was a mortgage lending business, and the other was a real estate transaction business.

During 2011, the taxpayer withdrew $211,746 from his retirement account to support the new business. The other couple did not make similar financial contributions to the business.

During the first few months of operation, the taxpayer used his personal checking account to conduct banking for the business.

In November of 2011, the business opened a business savings account and a business checking account at another bank. Both accounts listed the business name and “corporation” as the legal designation. The taxpayer was listed as president and his wife was listed as treasurer. The other couple was not listed on the accounts and could not sign checks.

In December 2011, the taxpayer opened another business account with the same bank. He was listed as both president and secretary. The other couple was not listed on the account and could not sign checks.

In October 2011, the taxpayer opened three new business accounts with a third bank (checking, savings, and a “trust” account). Each account agreement listed the taxpayer as the sole signatory, and the business designation selected for each account was “Sole Proprietorship,” with the taxpayer listed as the sole proprietor.

The two couples had different roles and responsibilities in the business. The taxpayer oversaw office operations and his wife oversaw the real estate agents. The other couple served as broker of record and were responsible for marketing, structuring loans, and overseeing loan processing.

The business was run very informally. The couples did not consult or employ any tax professionals. They did hire a bookkeeper, who used software to maintain the company’s books and records. However, as business declined they were unable to pay the bookkeeper.

The taxpayer controlled the business funds, used business accounts to pay personal expenses and personal accounts to pay business expenses, and did not maintain books and records tracking the payments.

The taxpayer also used funds from the business accounts to pay expenses such as utility bills and car payments for the other couple. The record does not include reliable evidence showing how much was paid.

The taxpayer says the couples agreed to an equal division of profits but acknowledged at trial that this did not occur. The record shows irregular cash withdrawals by the taxpayer and some payments to the other couple along with commission payments and “draws” to other associates. These cash withdrawals exceed the documented payments to, or on behalf of, the other couple.

The business was never incorporated, was never profitable, and ultimately failed. At the end of 2012, the couples agreed to part ways, and the other couple agreed to buy the taxpayer’s interests in the business.

The taxpayer filed timely joint federal income tax returns for 2011 and 2012. The returns were prepared by the other couple, who also prepared their own joint federal income tax returns. The other couple were not tax professionals and did not have a tax background.

Both couples reported business income on Schedules C for tax years 2011 and 2012. No Form 1065, U.S. Return of Partnership Income, was ever filed for the business.

The IRS determined that the taxpayer had unreported Schedule C gross receipts of $42,985 for 2011 and $121,053 for 2012.

The taxpayer said the gross receipts were the revenue of a partnership and should have been split among the partners. He argues that because business profits should have been split, the gross receipts reported on the joint return that he filed with his wife were overstated and should be adjusted downward, not upward, to account for the amounts attributable to the other couple and reported on the other couple’s Schedules C for these years.

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In a partnership, each partner is taxed on only their distributive shares of the partnership’s income (internal revenue code section 702). Each partner’s distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement.

Internal revenue code section 301.7701 controls the classification of “partners” and “partnerships” for federal tax purposes. That section defines a partnership as a business entity with two or more parties. The hallmark of a partnership is that “the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.”

To determine whether a partnership existed in this case, the court considered eight factors. Based on the information above, how would you answer the questions?

 

1. The agreement of the parties and their conduct in executing its terms

or

 

2. The contributions, if any, which each party has made to the venture

or

 

3. The parties’ control over income and capital and the right of each to make withdrawals

or

 

4. Whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income

or

 

5. Whether business was conducted in the joint names of the parties

or

 

6. Whether the parties filed federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers

or

 

7. Whether separate books of account were maintained for the venture

or

 

8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise

or

 

 

Considering the above answers, what would you decide?

or

 

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Right answer!

The couples did not reduce the terms of their agreement to writing. A partnership agreement may be entirely oral and informal, but the parties must demonstrate that they complied with its terms.

While the couples may have agreed orally to an equal division of profits, the taxpayer acknowledged that this division did not occur. The taxpayer withdrew varying sums of money from the business at irregular intervals.

The other couple could not withdraw money directly but instead received irregular payments in amounts different from the withdrawals and payments by the taxpayer.

The taxpayer directs us to the other couples’ returns to show that they already reported their shares of the business income. The taxpayer, however, never established that the other couple did not receive income from other sources.

This factor, therefore, weighs against finding that a partnership existed.

Right answer!

The taxpayer withdrew $211,746 from his retirement account and used these funds, in part, to capitalize the business. We have no credible evidence that the other couple made any capital contributions.

However, the taxpayer and the other couple each performed services related to the business.

We, therefore, will weigh this factor as favorable.

Sorry, wrong answer :(
Sorry, wrong answer :(
Right answer!

The taxpayer argues that the other couple had equal rights to withdraw funds from the accounts, but the credible evidence before us indicates that the taxpayer had sole financial control. The taxpayer was the signatory on all of the business accounts throughout the business’ existence; the other couple never were.

While the record shows that the taxpayer made payments to or on behalf of the other couple, no evidence shows that the other couple had rights to withdraw funds from the accounts.

This factor, therefore, weighs against finding a partnership existed.

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The IRS asserts that the other couple had a separate business and were independent contractors who were paid commissions.

The taxpayer asserts that the compensation of the couples was contingent on the proceeds from the business and they did not have fixed salaries.

The other couple played a role in the business, but the evidence is not sufficient to show that their role was coproprietors rather than independent contractors. Business owners, for example, may agree to compensate key employees with a percentage of business income, or brokers may be retained to sell property for a commission based on the net or gross sale price.

The record shows that payments to independent contractors were labeled commission payments and draws, like payments made to the other couple. The only evidence that the other couple received payments more akin to a partner’s share than an independent contractor’s commission or draw is uncorroborated testimony. We do not find this story credible.

This factor, therefore, weighs against finding a partnership.

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As the business’ bank records reflect, the accounts were held in either the taxpayer’s name alone and included the names of the businesses. The other couple were not listed on any of the accounts.

Further, the taxpayer designated the business as either a sole proprietorship or a corporation, not a partnership.

This suggests that the couples both treated the business as their own sole proprietorships–not a joint enterprise–not just on their Forms 1040, but also to financial institutions (and potentially check recipients).

This factor, therefore, weighs against finding a partnership existed.

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Right answer!

The taxpayer did not prepare and file a Form 1065 for the business for either taxable year at issue. Instead, he reported the income and expenses on his Schedule C.

The taxpayer asserts that he represented to others that he and the other couple were joint venturers and informed the IRS during the examination that they operated a partnership.

The IRS disputes this characterization.

We need not resolve this dispute. The taxpayer’s uncorroborated testimony cannot overcome the reporting of income and expenses on the personal income tax returns and the bank account records in evidence.

We find, therefore, that this factor weighs against finding a partnership.

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The taxpayer contends software was used to maintain separate books and records at the entity level. The taxpayer failed to produce any evidence that separate books and accounts were maintained other than uncorroborated testimony.

The business bank accounts were held in the taxpayer’s name and the taxpayer also admits that he used business accounts for personal expenses and personal accounts for business expenses.

This factor, therefore, weighs against finding that a partnership existed.

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The taxpayer and the other couple testified that they each assumed separate roles in the real estate and mortgage activities, and the record supports a finding that they had a business relationship in which they had different roles.

But the fact that they may have performed separate functions does not convince us that they exercised “mutual control” and “mutual responsibilities” indicative of a partnership, notwithstanding their conclusory testimony.

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Right answer!

Considering the record as a whole, we conclude that the business is not properly classified as a partnership for tax purposes.

While the record indicates that the taxpayer and the other couple had some sort of relationship, the record does not support a conclusion that the business was a partnership.

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