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Tax Law

Subchapter K: In or Out?

by Dmitriy Kustov CPA EA MS Tax *

Sub K's Cubist Period

The word, "partnership," has so many common place meanings and could mean so much these days that we should not blame those taxpayers who do not understand all the technicalities of partnership for tax purposes. Curiously, the Wikipedia's article on partnerships admits that federal law does not have a clear rule for what is a partnership. As a result, the Internal Revenue Code is as close as it gets to the authority on the federal level as to what a partnership really is:

Although the federal government does not have specific statutory law for establishing partnerships, it has an extensive and hyperdetailed statutory scheme for the taxation of partnerships in the Internal Revenue Code. The IRC is Title 26 of the United States Code wherein Subchapter K of Chapter 1 creates tax consequences of such great scale and scope that it effectively serves as a federal statutory scheme for governing partnerships.

The Code and volumes of treasury regulations, a legion of court cases, numerous IRS rulings, and countless other materials have scrutinized, analyzed, examined, and dissected partnerships. Despite this apparent complexity and seeming completeness, these sources provide many safe harbors but cannot always answer the ultimate question of how to get in or out of Subchapter K partnership. Why is this task so difficult?

This situation exists, to some extent, because the word itself and even its use in the Code have many connotations, as will be discussed later. Also, the ready availability of this flexible and convenient form of business entity continues to draw schemers devising and implementing abusive tax transactions, especially with the flow-through of profits and losses and the resulting ability to allocate income to tax exempt, foreign, and loss-carrying entities, while allocating losses to non-tax exempt, domestic, and profitable taxpayers. The Service and the courts have responded on multiple occasions by either disallowing or invoking partnership form. As is often the case, broad brushstrokes were applied that possibly affected otherwise innocuous arrangements and made the analysis murky.
The definition of a partnership had a makeover in 1999 when regulations proposed in 1997 became final. Prior to that time, the regulations merely repeated the Code for the most part or tried to explain or paraphrase various terminology used in the Code. The issued regulations made it easier to lean towards partnership or corporation. We still needed to operate, however, with a notion of an entity or joint undertaking that was very similar to "partnership" as meant by the good ol' definition of the 1932 Code.
The regulations introduced a term "organization for federal tax purposes." [Treas. Reg. § 301.7701-1(a).] This term is a wide net ready for any kind of collaboration between any two parties. The term is not specifically defined but is implied to include any "contractual arrangement." [Treas. Reg. § 301.7701-1(a)(2).] Thus, a business or financial relationship–no matter how formal or informal–may create an "organization for federal tax purposes." [Id.] A programmer, artist, and investor pooling resources and efforts to produce a computer application can be such an "organization." A real estate investor borrowing cash from a friend is another example. Any business or financial relationship is a suspect "organization." If such a relationship is recognized as an "entity separate from its owners," it defaults into an "abyss" or "saving grounds" (depending on the situation) of Subchapter K. Single owner organizations may be recognized as well [See Treas. Reg. § 301.7701-1(a)(4) .]  and are also referred to as "wholly owned entities" under Treasury Regulation Section 301-7701(c)(2), but are clearly outside of Subchapter K.

The term, "partnership," means a "business entity" that is not a corporation under paragraph (b) of this section and that has at least two members. [Treas. Reg. § 301.7701-2(c)(1)
.] A "business entity" is any "entity recognized for federal tax purposes" that is not properly classified as a trust under Treasury Regulations Section 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code. [Treas. Reg. § 301.7701-2(a).] An arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility themselves and, therefore, are not associated in a joint enterprise for the conduct of business for profit. [Treas. Reg. § 301.7701-4(a).] The beneficiaries of such a trust, however, may be the persons who created it. A trust will be recognized as such under the Internal Revenue Code if it were put together for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. [Id.]
Dmitriy Kustov, CPA, EA, MS Tax (Golden Gate University) has more than 15 years of experience in tax return preparation and tax consulting. He runs a boutique San Francisco accounting firm specializing in various tax issues concerning small and medium size businesses.

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