There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Two friends purchase and operate a short term rental. Together. They split the rental income and the expenses 5050. One manages the bookings while the other handles the repairs. They never wrote up any sort of document or [00:00:30] agreement for how they would operate this activity, and they never registered an LLC or any other kind of entity for this. Here's the question. Did they create a partnership and therefore, do they have some sort of partnership tax filing requirement under federal tax law? Now, what if instead these two friends are a married couple instead? What if they flip houses instead of renting them. What [00:01:00] if one spouse does all of the work, while the other occasionally helps out with some of the administrative tasks? These are everyday questions that clients and prospective clients and colleagues of mine come up with, and they all center on the same sets of questions, and they continuously come up and confound both taxpayers and tax professionals. [00:01:30] And that is whether an activity is for federal tax purposes, a partnership. So that's what we're going to talk about in this episode. In the next episode, we're going to look at partners and some specifics about partners. But before we look at partners, we first have to understand the basics of partnerships. Now this question of whether a partnership is formed or not, it's not an academic one, although that's an interesting Discussion to whether a partnership [00:02:00] exists for federal tax purposes and more importantly, when it came into existence, when that activity became a partnership is an important question for tax reporting and planning.
Jeremy Wells: There are, of course, reporting requirements for partnerships such as filing a partnership tax return, but there are also important tax planning considerations that are unique just to partnerships. Now, as Laura and Noel Cunningham [00:02:30] argue in their law school textbook, The Logic of Subchapter K A Conceptual Guide to the Taxation of Partnerships. Partnerships can be viewed in two ways under federal tax law. They can be viewed as an aggregate of the individual members or partners. In other words, they are just cooperatively but separately as individuals. Managing and owning and operating this activity. Or [00:03:00] we can look at a partnership as a single entity that's just comprising multiple individuals or other partnerships or corporations or other members, participants within that activity. But the partnership itself is a single entity distinct from any of those members or partners. Now, federal tax law actually takes a hybrid approach here. Sometimes it treats a partnership as an aggregate, as a bunch of separate [00:03:30] individual participants, all sort of cooperatively acting together. Or sometimes it treats it as an entity, a separate taxpayer, if you will separate from all of the members or participants of that activity, where problems can happen and real money can be lost due to misunderstanding or misapplying the law is when taxpayers and their advisers don't understand how [00:04:00] tax law is treating that partnership on that particular issue and failing to appropriately apply the right treatment to an activity.
Jeremy Wells: So this is actually a real important question to understand and to evaluate when it comes to working with small businesses and small business owners. So in this episode, we're going to focus on a few objectives here. So by the time [00:04:30] you finish listening to this episode or finish this course, then you should be able to do the following. First of all, define a partnership under federal tax law that's going to be basic. We're going to look at what a partnership actually is under federal tax law. And you would think that might be straightforward. It's actually very complex. There's a lot of both statutory and regulatory law that goes into that. And there's also a lot of case law that goes into it. And I'm just going to summarize just a very little bit of that for this episode. [00:05:00] Uh, second, explain how an activity can elect out of subchapter K. Subchapter K is the portion of the Internal Revenue code that deals with partnerships. And we'll talk about some ways that activities can actually avoid partnership treatment and instead opt for some sort of simpler tax treatment. We're also going to distinguish qualified joint ventures and LLCs [00:05:30] co-owned by spouses. A lot of times in discussion, especially online, I see these two concepts conflated. We're going to talk about how they're different and why those differences matter. And then we're going to determine whether or not a partnership exists under federal tax law based on facts and circumstances.
Jeremy Wells: So we'll look at sort of a case study toward the end here. So first of all, the federal tax law definition of partnership. That term includes syndicates, groups, [00:06:00] pools, joint ventures and other unincorporated organizations. Excluding corporations, trusts and estates. And that comes from IRC section 761 a. And that is again part of subchapter K, which is the part of the IRC that deals with partnerships. So that is a pretty broad definition of partnerships. Essentially, any activity that has some sort of [00:06:30] business like structure to it that involves more than one individual participant. Now, there are some limitations on this. A joint undertaking merely to share expenses or mere co-ownership. And these terms come from the associated regulations does not create a separate entity for federal tax purposes. So there are two different places where we get the definition of a partnership. The first [00:07:00] one, as I already mentioned, is in section 761 A. The second one is in section 7701. A two 7701 is just a list of definitions. If you are curious about how the Internal Revenue Code defines a certain term, then one of the best places to go to look. If you're struggling to come up with definition is section 7701. It might that term might actually be defined there. 7701 A2 gives us the definition [00:07:30] of a partnership. And like I said, the associated regulations also break this down a little bit further.
Jeremy Wells: Now that that federal tax law definition of partnership seemingly includes a lot of different kinds of activities involving more than one participant, that's a that's the bare minimum for a partnership. We've got to have more than one participant. And even that can be a complicated question. So for example, if an individual registers an LLC and wholly [00:08:00] owns that LLC, is that a separate participant under federal tax law? Because under federal tax law, that single member LLC is also probably a disregarded entity means it doesn't really exist for federal tax purposes. So are those two different participants or is it really just still the same individual anyway, let's assume that we have two or more real differentiable participants involved in this. Then if they are [00:08:30] participating collectively in this activity, is it a partnership? So a joint venture or other contractual arrangement may create a separate entity for federal tax purposes. If the participants carry on a trade, business, financial operation or venture and divide the profits therefrom, and that comes from the regulations. However, it also can include [00:09:00] several kinds of activities that either are not subject to or collect out of federal partnership tax rules as long as they qualify. And I'll talk about this a little bit more later. Now, this mere Co ownership is an important, uh, aspect of this discussion to keep in mind. Co-ownership, even of an income producing property such as a rental property, doesn't necessarily give rise to a partnership [00:09:30] under federal tax law.
Jeremy Wells: In other words, two unrelated parties or even two related individuals co-owning some activity, even if that activity is income generating, doesn't necessarily mean that a partnership has been created. So, for example, if two unrelated individuals purchase a single family home and rent that out, they divide the ownership, the income, the expenses, the managerial tasks evenly, or according to some understanding [00:10:00] between them, that does not necessarily constitute a separate entity for federal tax purposes. That's what the regulations define as mere co-ownership. However, if they offered additional services to tenants for fees, or if they intended to develop a portfolio of rental properties and carry that activity on like a trade or business, then the activity [00:10:30] may actually give rise to a separate entity or a partnership for federal tax purposes. Now, again, Cunningham and Cunningham, they assert that the two features that distinguish an entity from mere co-ownership are what they call business activity and the sharing of profit. And when you have both of those together involved in the activity, then they argue [00:11:00] that you probably have an actual partnership. So if you think about two individuals jointly purchasing a taxi cab, and this is the example they give. Now we don't really have taxis anymore because we have ride sharing. But let's, let's assume that we have a taxi cab. And these two individuals, they, they co-own it, uh, for each to use 12 hours a day.
Jeremy Wells: So one is going to drive the first 12 hours a day. The other one's going to drive the other 12 hours of the day, and they [00:11:30] are going to separately track the fares that they collect and the expenses, the gas that, you know, is required for their shifts. Then a partnership, they argue would not exist because they lack that joint profit motive. They just merely co-own the taxi. They're not collectively operating it with a shared profit motive. If it's my 12 hours [00:12:00] to drive that taxi cab, then I'm trying to make as much profit for myself during that 12 hours as I can. And however much profit I make during my 12 hours of driving, that taxi has no effect on the profit that you make during your 12 hours of driving that taxi cab around. However, if we co-own that taxi cab and instead we're going to lease it to some third party, and that third party is going to drive it and they're going, that third [00:12:30] party is going to try to collect the fares and pay the maintenance expenses, but then they're going to pay us some sort of leasing, uh, arrangement for the use of the cab that we own. Now we have a combined a collective profit motive, at least according to Cunningham and Cunningham. So the principal question here, right. The thing that we as a tax advisor of these two co-owners of this taxicab would be interested in is whether [00:13:00] their activities with respect to this cab, uh, rose to the level of the conduct of a business.
Jeremy Wells: And this would depend on whether they, for example, shared the various expenses for keeping up the cab as opposed to just simply sharing the rental payment that they collected, uh, but separately. Right. So it's going, it's not going to be black and white. There's not going to be a clear line in a lot [00:13:30] of these activities. Just because you have co-ownership doesn't necessarily mean you have a partnership. And just because you have an arrangement where even the partners are collectively generating income from the activity, doesn't necessarily mean that there is, in fact, a partnership. Really, what it comes down to at this point in the discussion when we're dealing with co-ownership, is whether there is that shared profit motive. [00:14:00] Now we'll talk more about this definition of a partnership and how courts have interpreted this, because they interpret it slightly differently. Now, a key thing to keep in mind here, because we have this federal system in the United States where we have both a federal government and we have state governments. And their authority when it comes to regulating [00:14:30] business tends to overlap, is we have to keep in mind that there is a difference between the way states define partnerships and just business more generally, and the way federal tax law defines partnerships. So federal tax law, not state or local law, determines if an organization is a separate entity or even an activity.
Jeremy Wells: If there's not an organization [00:15:00] is a separate entity, such as a partnership or an association for federal tax purposes. Now, according to Treasury regulations, a domestic eligible entity. Here we're talking about something like a limited liability company that has been registered in a state within the United States with two or more members that has not filed an entity election, meaning it's not elected to be treated as a C corporation or S corporation is treated as a [00:15:30] partnership. This is where we get that general rule that a multi member LLC is for federal tax purposes. A partnership unless it elects to be something else. Now, a foreign eligible entity with two or more members, at least one of which does not have limited liability and that hasn't filed an entity election, is treated as a partnership. So if it is a domestic entity registered in one of the states [00:16:00] within the United States, then all we need to know is that it has two or more members. If it is a foreign eligible entity, we need to look at whether any of those individuals does not have limited liability. If any individual in that arrangement does not have limited liability, then that is treated as a partnership under federal tax law. If they all have limited liability, then it's going to be treated generally as an association, as something [00:16:30] that's not a partnership that comes from regulation section 301 77011.
Jeremy Wells: And then 77013 uh 7701 is where we get, uh, essentially the outline for that part of the regulation 77013 is where we get much more detail about the definition of what the different kinds of business entities are. So those two rules about domestic eligible entities and foreign eligible [00:17:00] entities, those come from three section regulation, section 301 77013 B. So if you're not sure about an entity, especially if it's a foreign entity, be sure to reference that, uh, part as to whether it's going to be a partnership or something different. Now, just like federal tax law determines whether a partnership exists, it also determines when a partnership forms. And this is something [00:17:30] that we usually don't ask about, but it's actually a critical question is when does that activity actually start for federal tax purposes? Because that's going to determine when it has a filing requirement, right? So a partnership forms for federal tax purposes. When the participants join capital or services together intending to conduct an enterprise or business. So there's two [00:18:00] parts to this. The first one is the intent. They have to intend to conduct some sort of enterprise or business together. Now it's said that you can't prove intent and that's true. However, the courts have developed a series of criteria that they use in order to try to assess whether the participants actually had an intention Of conducting some [00:18:30] sort of enterprise or business together. And in general, that means that they did.
Jeremy Wells: They're not just trying to evade federal tax. Uh, that's that ends up becoming the key in a lot of these cases, especially involving, uh, family partnerships in the 40s and 50s and 60s, the, uh, the courts had to deal with several cases, several important cases that became fundamental in establishing, uh, [00:19:00] case law with respect to partnerships where family members, close family members, uh, such as parents and children or spouses would create partnerships in order to create the kinds of tax outcomes that they were trying to essentially artificially generate. And so the courts had to look at whether a partnership genuinely existed or not. And in the case where the participants weren't [00:19:30] actually trying to conduct some enterprise or business together, but instead we're just trying to avoid tax, then the courts pretty much shot those down and said that a partnership doesn't really exist here. It didn't really form now. So that's the first part of the, uh, determination of when a partnership forms is whether that intention existed. The second part is when the participants join their capital or services or some combination [00:20:00] of the two together. In other words, they have to put something into it. They can't just have plans to do this. It can't just be discussions. It can't even just be an agreement. There needs to be some actual contribution, something tangible, either in the form of money or property or real service to This collective activity, this partnership.
Jeremy Wells: Now this holds regardless of [00:20:30] whether a state law recognizes an entity or a partnership. So in other words, for federal tax law, the partnership doesn't come into existence when an LLC is registered with the state or even a limited partnership. An LP is registered with the state that might create an entity on the state's books, but it does not create the partnership [00:21:00] for federal tax purposes. What creates that partnership is when, with the intent to conduct that enterprise or business, the participants come together and actually contribute capital and or services into that activity. And at that point, the partnership has formed for federal tax purposes. Now partnership is deemed formed on the date that the first participants acquired their [00:21:30] respective capital interests in the partnership in exchange for contributions of either capital or services. So there should be ideally some sort of documentation. And this is something that a lot of small business owners don't do well at, but we as their tax advisor should be helping them and encouraging them in this direction. When those participants can document that they have contributed [00:22:00] either capital or services or some combination of the two and in exchange received back from the partnership their ownership interest in it. So, for example, if two individuals, they want to combine their efforts into a partnership to start a business, They can register an LLC. They can register a DBA or doing business as. They can register a URL, [00:22:30] a domain on the internet.
Jeremy Wells: They can even start buying supplies, buying inventory, all of these kinds of things. They can have conversations about what the partnership is going to do and what it's going to look like. They can start looking at retail space to operate out of. It's not until they have actually contributed some capital or services into that activity, and in exchange, received some sort of ownership interest in that activity. [00:23:00] It's not until that actually happens that the partnership is formed. So what should happen ideally is some sort of documentation, usually in the form of what we call a partnership agreement, or if it's an LLC, an operating agreement, there should be some documentation of when that actually happens. Now this is not just me making this up. This is all based on questions of whether partnerships have formed and when they formed that have gone all the way to the US [00:23:30] Supreme Court. Like I said before, in the 40s and 50s, there were several of these cases that went through the tax courts, went through the federal court system, made it all the way to the Supreme Court asking whether or not a partnership had actually formed. And when it formed. A couple of the seminal cases in this are tower V Commissioner 327, US 280 in 1946, and then Culbertson V Commissioner 337, [00:24:00] US 7331949. Now in tower, the US Supreme Court upheld a Tax Court opinion, finding that a partnership is generally said to be created when persons join together their money, goods, labor or skill for the purpose of carrying on a trade, profession or business.
Jeremy Wells: And when there is community of interest in the profits and losses. So again, we go back to that shared profit [00:24:30] motive. When the existence of an alleged partnership arrangement is challenged by outsiders, the question arises whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses of both. And their intention in this respect is a question of fact. That's what the Supreme Court said in tower. So the court are going to have to look at any [00:25:00] sort of evidence or testimony that's going to support the notion that the participants intended to form this partnership and operate as a partnership. Now, also in tower, there was a question of whether the state law entity, the date that that was formed, aligned with the formation date for federal tax purposes. And this is where the Supreme Court determined [00:25:30] that there can be a difference between state law and federal law with respect to this question, and that when it comes to federal tax law, the definition under federal tax law is what's going to matter. So a state cannot, by its decisions and laws governing questions over which it has final say, also decide issues of federal tax law and thus hamper the effective enforcement of a valid federal tax levied against earned income. [00:26:00]
Jeremy Wells: In other words, you can register whatever you want with the state. You can show whatever you've done with the state as a way of saying that, yes, we formed this partnership. None of that matters what actually matters for federal tax law is whether you've met the definition of a partnership under federal tax law. Now, in culvert in Culbertson, the Supreme Court clarified some of the interpretation of tower. [00:26:30] So in the intervening couple of years, the tax court, as well as some of the appellate courts, took some of the things that the Supreme Court had said in tower and kind of ran with them and ran with them in a direction that the Supreme Court did not intend. So the Supreme Court clarified some of its meaning in tower, in its opinion, in Culbertson a few years later. The question is not whether the services or capital contributed by a partner are of sufficient importance to [00:27:00] meet some objective standard supposedly established in that tower case. But whether, considering all the facts, the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise. In other words, by saying that the members had to come together and contribute some sort of capital and services. The courts took that opinion to mean that they had to put in some minimum amount, and that's not really what the Supreme [00:27:30] Court meant. Rather, what they meant was that that's going to that sort of activity, that that contributing capital or services is one way of determining when that partnership has formed.
Jeremy Wells: But there are other facts as well that matter. And I skipped this list because I wanted to come back to it here. So here are the list of things that the courts are looking for coming out of this Culbertson decision. So first of all, the agreement I mentioned earlier, there should ideally be a written agreement [00:28:00] among the participants, the partners, the members, whatever the conduct of the parties and execution of its provisions, are they all cooperatively participating in this are their silent partners who are just putting in capital. Are their working partners who haven't contributed capital, but they're contributing services? Are there individuals kind of on the fringes that haven't really done much of anything, but for some reason they're included in the list of participants, even though they're not really participating [00:28:30] in the activity. We need to look at each individual and determine whether that individual is actually part of this arrangement or not. Like I said, in the next episode, we're going to get more into what it means to be a partner, and Culbertson is actually going to come back up as an important case in that question as well. Uh, their statement, uh, the testimony of disinterested persons. In other words, would other people, uh, would vendors, business [00:29:00] associates, advisors, would they look at this activity and say, oh, yeah, that, that seems like a partnership.
Jeremy Wells: It seems like it's multiple individuals that are collectively acting together, or would they describe it as something different? The relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it's used, and any other facts throwing light on their true intent. In other words, it just comes back to intent [00:29:30] to participate collectively as a partnership. And whether that intent seems like it's there or not. So again, the intent to form a partnership along with actually forming one, right? So there has to be both the intent to form that partnership. And then at some point they've got to actually form it. Uh, that became the leading criteria in determining both whether and when a partnership formed. There are some [00:30:00] other cases here. Hensel Phelps Construction Company V Commissioner 74 TC 939 in 1980 and then Luna v Commissioner 42 Tax Court 1067 1964. Those are a couple of other seminal cases in this discussion. Now, evidence of intent to form a partnership that can include the partnership agreement contributions made control over the income and capital of the venture and the right to make withdrawals [00:30:30] what we call partner distributions, whether the parties are co proprietors who share in net profits and who have an obligation to share losses. That comes from some of the court's language there, and then whether businesses conducted in the joint names of the parties and is represented by a partnership.
Jeremy Wells: That list of criteria actually comes from the IRS revenue ruling 8261. And that revenue ruling, uh, can [00:31:00] provide a bit of standard for us as well in determining whether an activity is a partnership or not. Sparks v Commissioner. 87 Tax Court 12791986 is another tax court case that, uh, helps us understand when a partnership has formed. So in this case, there were, uh, startup discussions, solicitations of contributions, negotiations with third parties, [00:31:30] and even some expenses incurred. But what the tax court said was that none of that is the actual formation of the partnership. Rather, those things are all what the court called pre operating activities, or we might call them, you know, startup expenses or startup efforts. Right. The partnership did not form until those members capital interests had vested, until they had made the contributions and in exchange, [00:32:00] received some interest in the partnership. Everything else that happens up to that point, conversations among the participants, conversations with third parties, even expenses coming out that are paid by one of the lead participants. None of those things truly indicates the formation of a partnership. And Luna is an interesting case because an insurance agent attempted to categorize a lump sum payment [00:32:30] from the insurance company for rights to receive renewal commissions. After this agent was going to leave this company, I tried to report that at that lump sum payment as a capital gain rather than ordinary income.
Jeremy Wells: And the argument was that if the payment was in exchange for an interest in some joint venture with the insurance company, and the court pretty much threw this logic out and said, no, the insurance agent is an employee, [00:33:00] an employee, and the employer, they are not in a joint venture. That is a separate kind of arrangement. That is not a joint venture. So there are some relationships that even though there is a shared interest, that it's not for federal tax purposes going to qualify as a partnership. Luna also gives us some more criteria that are helpful and restate some of the criteria. So, you [00:33:30] know, none of these criteria that we've discussed so far are going to be individually conclusive of determining whether a partnership exists, but they do provide a helpful set of criteria for thinking through whether a partnership exists and importantly, when it actually forms. Now an activity can elect out of subchapter K treatment. In other words, it can elect out of the rules [00:34:00] of subchapter K that provide the rules for partnerships in federal tax law. The members of an unincorporated organization. And this is key. It has to be an unincorporated organization can elect out of subchapter K if the members can adequately determine their incomes without the computation of partnership taxable income, and they use the activity for investment [00:34:30] purposes only for the production, extraction or use, but not sale of joint property or buy securities dealers for underwriting, selling or distributing a particular issue of a security over a short period.
Jeremy Wells: Now this comes from IRC section 761 A, which back earlier that [00:35:00] gave us the definition of a partnership in subchapter K. So immediately we have a group of activities that are listed out as not being subject to subchapter K treatment if they elect. So now regulation section 1.7612 provides a lot more detail and some examples. And the actual rules for making that [00:35:30] election. And in fact it even provides for either a complete or partial exclusion from subchapter K. So it's possible for an activity to say that they only want to partially exclude themselves from some parts of subchapter K and not others. Now, regardless of how it makes that election, it's irrevocable unless the commissioner provides explicit approval, meaning the IRS has to approve that [00:36:00] that revocation of the election out of subchapter K treatment. Now, it's important to keep in mind that this is an election out of subchapter K treatment. It is not an election out of any other aspects of the Internal Revenue Code in Bryant v Commissioner 46 Tax Court. 8481966 which was then affirmed by the Fifth Circuit and in Cox v Commissioner 91 [00:36:30] Tax Court 2221988. The Tax Court has held that all of the other aspects of the Internal Revenue Code still apply to that activity. In fact, a partnership remains a partnership for federal tax purposes. It's just electing out of subchapter K rules in Cokes, for example, a member of an oil mining joint venture challenged an [00:37:00] assessment of self-employment tax.
Jeremy Wells: Now, that comes from a whole different part of the Internal Revenue Code than subchapter K on income derived from the venture. The the, uh, folks here inherited the interest in this activity after her husband died. The written agreement between Koch's husband and now coax herself and the activity itself included specific language that each member [00:37:30] elected out of subchapter K treatment. So this was a complete election out of subchapter K treatment. Moreover, according to the court, the Koch's wife, who inherited this interest never attended a meeting of the owners, never voted on any matter in connection with this venture, never obtained any oil and gas leases except the ones that she inherited from her husband. Never drilled any oil wells herself, never supervised [00:38:00] any water flood or secondary recovery operations, and never promoted any oil deals with anyone else. In other words, she had nothing to do with this venture other than inheriting her husband's interest. And despite all of that, the court still held that her income was derived from a trade or business and then therefore subject to self-employment tax under IRC section 1401 and 1402. Even though that partnership [00:38:30] agreement said that she elected out of subchapter K treatment. Now, Cunningham and Cunningham argue that activities can elect out of subchapter K treatment likely wouldn't be classified as partnerships. Anyway, we're talking about, uh, production extraction or use, but not sale of joint property.
Jeremy Wells: So that's that's on the verge of mere year co-ownership securities dealers for underwriting, selling or distributing a particular issue of a security over a short period. That's not a continued [00:39:00] business or trade. That's just a function of being in that line of business and then investment purposes only. Again, that that's going to be, uh, akin to mere co-ownership. So we're already talking about activities that don't really rise to the level of being a partnership. So why would they elect out? Cunningham and Cunningham say that essentially acts as an insurance policy for investors who want to make sure that they can make individual [00:39:30] tax selections with respect to the activity, that they don't have to rely on the partnership making tax decisions on their behalf. So the election out is probably going to be an affirmation of what's already true about that activity that it's not necessarily a partnership, although the courts have said it's still a partnership if it meets the other [00:40:00] criteria of being a partnership, and therefore it's still subject to all the rest of the Internal Revenue Code. I mentioned before, a couple of exceptions to partnership treatment that are available to married couples, and there are two and they are distinct. I will often hear these conflated, though, in discussions among tax professionals, especially online. It's important to understand that these are two very different regimes. [00:40:30] They both involve activities that are owned and operated jointly by married couples.
Jeremy Wells: However they exist, they are two different sets of rules for two different situations. So the first one is what's called a qualified joint venture. Spouses who file a joint return can report a business as a qualified joint venture [00:41:00] rather than a partnership if it meets all of the following criteria. First of all, the spouses are the only members of the activity. Second, both spouses materially participate, according to IRC section 469 H. There are material participation rules under section 469 and Reg section 1.4695 T. If both spouses materially participate, then they've met that criterion. And then third, each spouse reports [00:41:30] her respective share of items of income gain loss and deductions and credits as if she'd operated as a sole proprietor. So if the if the spouses do those things, if they file a joint return, they're the only members of the activity. They both materially Participate and they, uh, report their respective shares of all the items of income gain loss deductions and credits separately, as if they had each operated as sole proprietors. [00:42:00] Then they can do that. They can each file separate schedule C or F, depending on what kind of activity it is, and then a separate schedule S e to report their self-employment tax with their joint return, they must file a joint return. They cannot do this if they file separately. If they file separate returns, they have to file a partnership return. If they file a joint return, then they can report this as a qualified joint venture [00:42:30] under IRC section 761 F now the qualified joint venture, it allows spouses co operating a business and filing a joint return to split that partnership essentially into two sole proprietorships for reporting purposes.
Jeremy Wells: That gets them out of having to file that separate partnership return, and that can save them some compliance burden and maybe even some accounting fees if they don't have to file that [00:43:00] separate partnership return. Now, the election is not available if the spouses operate in the name of a state law entity, such as an LLC, and that is critical to keep in mind. If the spouse is registered an LLC and they operate through that LLC, the qualified joint venture approach is not available to them. There are some rules about whether they can use the partnership Ein or if they need a new one. They do [00:43:30] not need a new Ein for the qualified joint venture if it has employees. If that activity has employees and they report it as a qualified joint venture, meaning two separate schedule C's or F's. Then either spouse can report and pay the employment taxes due on wages paid to the employees using a sole proprietorship Ein that belongs just to that spouse. But they would not. Neither one of them would use the partnership ein [00:44:00] if they had already reported the activity as a partnership. If they already have an Ein for the partnership and they elect to report it as qualified joint venture, then that Ein remains with the partnership, and it's used by the partnership for any year in which they do not qualify as a qualified joint venture.
Jeremy Wells: If they receive IRS correspondence regarding an unfilled partnership return while reporting as a qualified [00:44:30] joint venture, then they should explain either on the phone or in writing that they properly reported the activity as a qualified joint venture on their jointly filed individual income tax return. There are no separate reporting requirements to say that they made the election. There's no statement. There's no separate form. Rather, they just file the two separate schedules C or F, and then the two separate schedules [00:45:00] S, E with their joint return. And the election remains in effect as long as the spouses meet the requirements for filing as a qualified joint venture, they can request permission from the IRS to revoke the election, but they can only revoke the election with permission from the IRS if they ever fail to meet the requirements for any given year of reporting as a qualified joint venture, then they [00:45:30] must report the activity as a partnership until they make a new election to report as a qualified joint venture. Okay, that's the qualified joint venture piece that's only available for spouses operating an unregistered activity. What happens if the spouse is registered an LLC? Generally, that is going to be a multi-member LLC, which is going to [00:46:00] report itself as a partnership for federal tax purposes.
Jeremy Wells: However, Revenue Procedure 2002 69 provides an exception only for spousal LLCs in community property states. So if the spouses operate the activity in a community property state and they hold their interest in that LLC as community property, and [00:46:30] they solely and wholly own that LLC, there are no other owners. The two spouses own it 100%. And it has not made a corporate election. Then the revenue procedure 2002 69 allows the spouses to report the activity either as a partnership or as a disregarded entity. It's their choice, and they make that choice each and every tax year. [00:47:00] And they can change that decision each and every tax year if they want. Probably shouldn't, but they could theoretically under this revenue procedure. So in other words, if it's a spousal LLC and they own and operate it as community property in a community property state, then they can make that choice whichever way they want to go. The community property states include Arizona, California, Idaho, Louisiana, Nevada, New [00:47:30] Mexico, Texas, Washington and Wisconsin. So if that LLC interest is held wholly and solely by two spouses in one of those states. They can make that choice. And it's not an election. There's no election to be made. There's no statement to be made. There's no form to file. It's a choice that doesn't have to be revoked. There's no request to make that election or to revoke that election because it's not an election. [00:48:00]
Jeremy Wells: It is simply a choice. And the IRS will respect the spouse's choice. With each year, this is going to be available to spouses with a state law entity that is not treated as a corporation in a community property state. So note there is a state law entity here that means that qualified joint venture election under IRC section 761 [00:48:30] F is not available in these cases. So that is an entirely separate regime available to spouses within operating activity that is not in a registered state law entity. So these are two distinct concepts. Qualified joint ventures under IRC section 761 F and spousal LLCs and Community property States under Revenue Procedure 2002 69. They both have a similar effect, but [00:49:00] they are separate regimes that apply to separate situations. So don't conflate them. Don't get them confused. Let's look at, you know, let's bring all of this together into a sort of framework for determining whether a partnership exists. This has been a lot of different criteria and sources of authority and some exceptions here. Let's try to pull it all together. And, and really, I think it can boil down [00:49:30] to two steps. The first step is a little complicated. There are some some substeps here, but really the first step is just determining whether a partnership under federal tax law exists. And here we can go through a series of questions. So first are there two or more owners. And that's always going to be the first question we have to ask.
Jeremy Wells: Are there two or more owners. And I go a step further and I say, are these really two distinct owners? If we're [00:50:00] talking about an individual that registers an LLC, but that LLC is really a disregarded entity, I'm not as inclined to call this a partnership. It really is just the single individual operating this. However, if we really have two distinct owners and they can be spouses, they can be parent and child, they can be siblings, but they need to be two separate, distinguishable taxpayers. Second, [00:50:30] are they merely co-owning property, or are they actually operating an activity together? Do they have a shared profit motive? Are is this an actual business activity? Right. Are they carrying on a business together? Are they actually acting like they operate a business or, you know, do they just own this activity? But other than that, they really don't have much to put into [00:51:00] it. Right. Uh, that means it's probably going to be more like an investment activity, which is by definition not going to be a partnership or probably not going to be a partnership. And then are they acting like co-owners of a business? Again, back to that shared profit motive. Do they each, uh, or, you know, does each of the participants, do they have a sense of some sort of collective Approach [00:51:30] to trying to derive profit and get something back out of this activity.
Jeremy Wells: Again, these are all gray area questions, and there's not going to be a line in the sand that's clearly going to delineate between yes or no. A lot of times there's going to have to be a determination made, and it's going to depend on asking more questions, having more conversations and making a judgment call. Uh, and that's going to be true a lot of [00:52:00] times. However, in the court cases that I covered earlier, there's going to be a lot of criteria that you can use as the basis for asking those questions, for collecting that information and ultimately making that determination. And then the second step here before we say, okay, this qualifies as a partnership, let's treat it like a partnership. The second step is going to ask if there's an exception. So the first one is whether that election under section 761 A is available. [00:52:30] Is this an activity that collect out of subchapter K treatment? Now all that's going to do is mean that it doesn't need to report as a partnership, but it's not necessarily going to mean that it's not a partnership for federal tax purposes. And it's definitely not going to mean that it has elected out of any other provisions of the IRC. So it's important to keep that in mind. If you're dealing with an activity that could potentially elect out of subchapter [00:53:00] K under section 61. A the other two exceptions are the qualified joint venture under section 61 F and then Community Property LLCs under Revenue Procedure 2002 69.
Jeremy Wells: So if you're dealing with an entity or an activity that is co-owned solely and wholly by spouses, then one of those exceptions might apply. But make sure you understand the determination. The definition [00:53:30] of a qualified joint venture and the requirements of that, as well as the Community Property LLC, and that you're correctly applying the right concept to the situation that you're dealing with. The more the parties look like business owners running an enterprise together, as opposed to just mere co-owners or spouses who are operating collectively, but really could be treating [00:54:00] this as separate, uh, sole proprietorships as opposed to a partnership. The more they look like they are business owners running an enterprise together, the more likely it is that a partnership exists. But again, it's never going to be clear cut. Yes or no. Um, and in some of these cases, and then the more they look like investors who merely happen to own the same property. The less likely it is that a [00:54:30] partnership exists. So let's look at a quick case study real quick. So two friends buy that short term rental together. They split the expenses 5050. One manages the bookings while the other handles the repairs. They never wrote a partnership agreement or registered an LLC. Did they create a partnership? Let's apply that framework. So first of all, does a partnership exist? Are there two or more owners? Yes.
Jeremy Wells: Right. There are two distinct individuals. Are they merely co-owning the property? It appears so. It looks like that. Um, [00:55:00] now it's a short term rental, so we should ask anyway, regardless of whether it's two owners or more owners or fewer owners, we should ask about whether they provide substantial services that might indicate that this is a business activity as opposed to just a rental activity or mere co-ownership. If they do, it's likely a business and therefore a partnership. But again, even that's not going to be determinative. What we really need to know is whether they just merely co-own [00:55:30] it, or whether they're collectively operating it as a partnership. Now, are they carrying it on as a business together? Probably not. A single rental is probably just going to be mere co-ownership. They're splitting expenses, you know, they don't really have a shared profit motive. They are just merely co-owning this. Um, so are they acting like co-owners of a business? No, not not likely. Right. They're just merely co-owning this [00:56:00] investment activity together. And then, you know, that pretty much leads us to say that no partnership probably doesn't exist here for federal tax purposes. But even if one did, is there an exception? Could they elect out under section 761 A perhaps as long as they merely co-own the property, Maybe they make that election to to make it clear to give themselves that insurance that Cunningham and Cunningham talk about. They're [00:56:30] not married and so qualified joint venture under section 761 F or Community Property LLC under prop 2002 69.
Jeremy Wells: Those aren't relevant. But if it were a married couple, possibly, uh, if we determine that it likely was a partnership under federal tax law, but they were a married couple, they haven't registered an LLC. So we could call this qualified joint venture under section 761 F if this were more of a business activity, for example. Okay, [00:57:00] a couple of takeaways here. One, the more the parties look like business owners running an enterprise together, the more likely it is that a partnership exists. So that's what we really need to be focusing on. If they look like investors who just merely happen to own the same property, they just co-own it, then it's likely that it's not a partnership. And then second, shared property doesn't necessarily create a partnership. But if they're sharing a business activity, then [00:57:30] they probably have formed a partnership. You're going to have to make some tough calls, make some determinations here, but do so after asking lots of questions, having conversations with the participants. Now, if you found value in this episode, please let me know by liking and leaving a comment in your podcast Application of choice or on YouTube. Of course, subscribing and for the next episode, like I said, we're going to look at partners and what the definitions of partners are and the different kinds of partners we can have under federal tax law. And a [00:58:00] very important question lately is whether some of those partners are subject to self-employment tax or not. Thanks for listening.