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The IRS has rules on business and
togetherness
By Cora M. Barnhart •
Bankrate.com
Sept. 30, 1999 -- When business owners believe
that two heads are better than one, they form a partnership. What
many of these individuals may not realize, though, is that joining
forces just to split expenses isn't a partnership.
For example, co-owning property and leasing
it out isn't a partnership in and of itself. The IRS wouldn't consider
this to be a partnership unless the co-owners also provided services
to the tenants.
So if just splitting expenses isn't enough to
be considered a partnership by the IRS, what is? This tax tip attempts
to explain this. It begins with the well-known perception of an
unincorporated organization. In the eyes of the IRS, the organization
isn't a partnership unless its members carry on a trade, business,
financial operation or venture, and divide its profits.
Family
partnerships: Capital or service?
One of the most common business partnerships is the type formed
by families. The IRS requires that one of two conditions be met
before it will recognize family members as partners. The condition
that is relevant depends on how the business makes its income. The
bottom line in dealing with either of these requirements? Each partner
must contribute either capital or service to the business.
- Condition 1: If a substantial part
of the gross income of the business comes from capital, the IRS
perceives the business as one where capital is a material
income-producing factor. This is common among businesses that
rely on substantial inventories or investments in plants, machinery
or equipment. If capital is a material income-producing factor,
the IRS places three requirements on the members of the partnership.
First, they must have acquired their capital interest in a bona
fide transaction. This transaction can even be the result of a
gift or purchase from another family member. Second, each member
must actually own a share of assets in the partnership. Finally,
each member must actually control his share of the assets.
- Condition 2: If the income of the
business consists of fees, commissions or other compensation for
personal services performed by members or employees of the partnership,
then capital isn't a material income-producing factor. In these
types of situations, the IRS expects members in a partnership
to have joined together in good faith to conduct a business. In
addition, they must have agreed that contributions of each entitle
them to a share in the profits.
Consider a business such as a restaurant, where
capital is a material income-producing factor. A father sells 50
percent of the business to his son. The resulting partnership earns
a profit of $60,000. Assume that the father performed services worth
$24,000 and the son didn't perform services.
When the IRS examines the situation above, they
would expect the father to receive $24,000 as compensation. This
would leave a total of $36,000, not $60,000, of profit for the members
of the partnership. The IRS would expect at least 50 percent, or
$18,000, be allocated to the father since he owns a 50 percent share
of the business. In other words, the son's share of partnership
profit can't exceed $18,000.
One of the most important aspects of a successful
partnership is an agreement understood by all members. According
to the IRS, the partnership agreement includes the original agreement
and any modifications. Any modifications must be agreed to by all
partners or adopted in any other manner provided by the partnership
agreement. The agreement or modifications can be oral or written.
Special
rules for spouses
Business partnerships between a husband and his wife are special.
Unlike other partnerships, if spouses go into business together
and share in the profits and losses, they can be partners without
drawing up a formal partnership agreement. If so, they should report
income or loss from the business on Form
1065. They should not report the income on a Schedule
C (Form 1040) in the name of one spouse as a sole proprietor.
Finally, each spouse should carry his or her share of the partnership
income or loss from Schedule
K-1 (Form 1065) to their joint or separate Form(s) 1040. They
should each include his or her respective share of self-employment
income on a separate Schedule
SE (Form 1040), Self-Employment Tax.
While this usually doesn't increase the total
tax on the return, its in each spouse's interest to do so since
it gives each spouse credit for Social Security earnings on which
retirement benefits are based. While it may seem like a pain to
split this figure up in this manner, it could be worth it (to at
least one of you) when it is time to collect those Social Security
payments.
-- Posted Sept. 30, 1999
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