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1. Partnership Defined - A partnership for federal income tax purposes is an unincorporated organization with two or more “persons” who carry on a trade, business, financial operation, or venture and divide its profits. For these purposes, a person can be an individual, a corporation, an estate, a trust, or another partnership. Partnership agreements need not be in writing.
2. A joint undertaking merely to share expenses is not a partnership. This would be true for a co-ownership of property rented to tenants with no services provided. However, if services are provided to tenants, then the organization will be a partnership.
3. For tax years after 1996, an organization of two or more members will be classified as a partnership if it is none of the following:
(1) A corporation under state law,
(2) A joint-stock company under state law,
(3) An insurance company,
(4) Certain banks,
(5) An organization wholly owned by a state government,
(6) Statutory corporations under the Code, such as publicly traded partnerships,
(7) Certain foreign organizations,
(8) A tax-exempt organization,
(9) A real estate investment trust,
(10) Statutory trusts under the Code, and
(11) Any organization electing to be classified as a corporation by filing form 8832.
In addition, certain investment organizations may elect to be excluded from partnership status if all members of the organization elect such exclusion. In effect, the default election for such members is a partnership. If there is only one member of an enterprise, a partnership is not an option; unless the “check the box” election is made to be taxed as a corporation, the entity will be disregarded (de facto, a sole proprietorship).
4. A partnership is a tax-reporting, not tax-paying entity. The partnership reports its income on Form 1065, which is used to allocate the income, deductions, and credits to the partners (who pay the tax). Though classified as a partnership, if the entity has no income, pays no deductions, and qualifies for no credits, a Form 1065. need not be filed. Partnerships with more than 100 partners must file Form 1065. and related Schedules K-1 electronically. The return must be signed by the general partner. The penalty for failure to file a 1065. is $85. per month (12 max) x number of partners.
5. The conversion of a partnership to a limited liability company (LLC) is not considered to be a liquidation of the old partnership or the formation of a new partnership entity; the LLC will continue the partnership’s tax year and ID number.
6. Family Members as Partners - Members of a family may be partners, provided that one of the two following conditions is met:
If capital is a material income-producing factor, the family member must have acquired the capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest, or If capital is not a material income-producing factor (i.e., services are), the family members join together in good faith to conduct a business, agree that contributions of each entitle them to a share of profits, and each provides some capital or service to the partnership.
7. A capital interest is more than a mere right to share in the profits; it is an interest in the assets of the partnership that would be distributed at withdrawal or liquidation.
8. When a capital interest is received by gift, the donee’s distributive share of income
(1) must be figured by reducing income by reasonable compensation for services the donor renders and
(2) must not be proportionately greater than the donor’s share when attributable to capital. A “sale” between a partner and a spouse, ancestor, lineal descendant, or trust benefiting those individuals will be treated as a gift for purposes of these rules.
9. The Partnership Agreement - A partnership agreement (or any subsequent modifications) need not be in writing.
10. A partnership agreement may be modified for a particular year after the close of the tax year but not later than the date for filing the partnership return for that year (ignoring extensions). If a partnership agreement is silent on an issue, the provisions of local law are presumed to be part of the partnership agreement.
11. Partnerships have much flexibility in allocating profits and losses in the partnership agreement, if, as explained later, the allocations have “substantial economic effect.”
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