There are significant risks if two related
proprietorships are really a partnership for tax reporting purposes. The
penalty has increased dramatically for failing to file a partnership return.
When does a partnership exist for tax purposes?
Nearly all farming and ranching operations are family
enterprises. And it is common to have two or more family members each operating
a proprietorship with some form of sharing arrangement. In some cases, it is
co-ownership of machinery; in others, it may include sharing of input expenses.
The IRS has stated the mere co-ownership of property is
not a partnership, nor is a joint undertaking simply to share expenses. So,
common sharing arrangements are not usually an issue. But if a common checking
account is involved and used for more than just a few shared expenses, it gets
murkier.
The question is whether two parties are sharing a common
business as partners or separately operating their own proprietorships.
The courts will look at a host of factors including:
• The
agreement between the parties
• The
contributions that each makes to the venture
• How the
business represented itself to the public
• How the
books were maintained
• Whether the parties exercised mutual control
over the enterprise
The Holdner Case
In the Holdner case, referred to above, a father and son
had been farming together for more than 30 years. Each reported as a farm
proprietor, with each individual reporting a 50 percent share of cattle sales,
timber sales, and rental income. But most of the expenses were claimed by the
father, who had other sources of income and apparently could make better use of
those tax deductions than the son.
The Tax Court found that the facts indicated the Holdners
were conducting a partnership rather than two separate proprietorship's. All of
the income and expenses were run through a single checking account labeled
“Holdner Farms.” They had registered with the state of Oregon as a partnership,
carried insurance as a partnership, and co-owned as tenants-in-common a number
of parcels of real estate.
The court determined that the expenses were arbitrarily
allocated primarily to the father each year purely to benefit his high-bracket
tax return, and they were not reflective of any business sharing agreement
between the two parties.
Consequences of filing incorrectly
Over the last several years, Congress has dramatically
increased the penalty for failing to file a partnership return. The Holdner
court case involved an IRS examination of the years 2004–2006. At that time,
the penalty would have been only $500 per year. Today the penalty is $2,340 per
partner for each year of non-filing. If the IRS successfully recharacterized
two proprietors as a partnership, and did so for three tax years, the total
penalty would be $14,040 (2 partners x 3 years x $2,340).
If the IRS creates a partnership, other tax issues also
come into play. For example, an individual proprietor is entitled to a full $250,000
Section 179 deduction for first-year depreciation. But as a partnership with
equipment that is owned by the partnership, there is only a single $250,000
first-year Section 179 deduction.
How we can help
The Holdner family could have accomplished their
objective (i.e., a greater share of expenses to the father) by actually filing
a partnership return and creating a more formal income and expense sharing
agreement. Partnerships are allowed to allocate income and expenses
disproportionately, provided that each person’s capital account properly
reflects his or her share of income and deductions and that the capital
accounts are used to reflect each party’s share of assets upon dissolution of
the venture.
