Editor: Mark G. Cook, CPA, MBA
Partners & Partnerships
In Chief Counsel Advice (CCA) 201323015, the IRS ruled that a joint collaboration between two corporations was a partnership for U.S. federal tax purposes and the entity could not elect out of the application of subchapter K of the Code. Additionally, the IRS Office of Chief Counsel (OCC) ruled that the determination of the Sec. 199 domestic production activities deduction (DPAD) for deemed partnerships producing qualified products must be done at the partner level. The OCC focused on factors from the U.S. Supreme Court in Culbertson, 337 U.S. 733 (1949), and the Tax Court in Luna, 42 T.C. 1067 (1964).
Corporation A and Corporation B collaborated to develop and market Product. According to the CCA, they entered into an agreement under which A granted B rights to co-promote Product. The two corporations kept complete and separate records. Moreover, the agreement specified that B would play the primary role in management, finance, and operations. A submitted its records to B so that B could determine the joint venture’s net income. B paid A for its allocable share of profits and losses. These reimbursements were originally treated as royalty payments from B, but, at some point during the venture, A claimed amounts from B as qualified production activity income (QPAI) for A’s DPAD.
A and B charged all costs incurred against operating profits of the joint venture. A and B were allocated their share of profits and losses as determined in the agreement. A and B never filed a Form 1065, U.S. Return of Partnership Income, nor did they file a written election under Sec. 761(a) to elect out of subchapter K. The agreement did not state whether the collaboration should be treated as a partnership for federal income tax purposes; however, side agreements included provisions that their relationship should not be treated as a partnership, agency, employer-employee, or joint venture.
Collaboration as a Partnership
Sec. 761(a) defines a partnership as “a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title [subtitle], a corporation or a trust or estate.” Partnerships must include at least two partners.
Joint undertakings formed merely to share expenses are not considered a partnership. However, any of the previously mentioned factors, as defined in Sec. 761(a), could give rise to a separate entity for federal tax purposes under Secs. 761(a) and 7701(a)(2).
The Supreme Court, in Culbertson, determined a joint undertaking was a partnership for tax purposes if:
- A partnership agreement existed;
- The parties represented to others that they were partners;
- The parties had a proprietary interest in the partnership profits and an obligation to share the losses;
- The parties had a right to control the partnership income and capital; and
- The parties contributed capital or services.
The Tax Court in Luna developed an eight-factor framework to determine whether a business venture should be a partnership for tax purposes:
- The agreement of the parties and their conduct in executing its terms;
- The contributions, if any, that each party has made to the venture;
- The parties’ control over income and capital and the right of each to make withdrawals;
- Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for its services contingent compensation in the form of a percentage of income;
- Whether business was conducted in the joint names of the parties;
- Whether the parties filed federal partnership returns or otherwise represented to the IRS or to persons with whom they dealt that they were a joint venture;
- Whether separate books of account were maintained for the venture; and
- Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
In weighing the Luna factors, the OCC did not treat any one of the eight factors as determinative and concluded that the collaboration was a joint venture. According to the OCC, five of the Luna factors supported the CCA’s conclusion, with the sixth factor against, and factors three and five as neutral. The OCC also determined that A and B’s collaboration agreement was entered into with a business purpose to earn profits. Considering all the facts and circumstances, the OCC found that the overall standard in Culbertson was satisfied and the collaboration should be treated as a partnership for federal income tax purposes.
Exclusion From Subchapter K Tax Treatment
Certain partnerships owning investments with specific attributes may allow the partners of such a partnership to elect out of application of subchapter K by reporting the income on their individual Form 1040 tax returns (Regs. Sec. 1.761-2(a)). This may be done if the income of each partner can be determined adequately without computation of partnership taxable income and the organization is availed of (1) for investment purposes only and not for the active conduct of a business, or (2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted. Since A and B had a business of producing and selling Product, and Product was not investment property, they did not meet the criteria for exclusion from partnership tax treatment.
The Sec. 199 DPAD is available to qualified taxpayers to encourage manufacturing and certain other production activities within the United States. The deduction equals a percentage (3% in 2005 and 2006; 6% for 2007–2009; and 9% after 2009) of net income from (1) QPAI or (2) taxable income for the year without regard to the DPAD. The deduction is limited further so that it may not exceed 50% of allocable W-2 wages. QPAI equals domestic production gross receipts (DPGRs) reduced by cost of goods sold and other deductions, expenses, and losses allocable to the receipts (Sec. 199(c)(1)).
DPAD is allowed for both regular and alternative minimum tax for C corporations; farming cooperatives; and estates, trusts, and individuals. The deduction is also allowed to partners and owners of S corporations, but not to partnerships or S corporations themselves.
A partner is allocated a portion of the partnership’s DPGR, QPAI, cost of goods sold, and other expenses and deductions attributable to those items. Sec. 199 applies at the partner level in a manner consistent with the economic arrangement of the owners of the passthrough entity.
As determined previously in the CCA, the collaboration between the corporations gave rise to partnership tax treatment. Accordingly, the DPAD must be calculated at the partner level. Under Sec. 199(d)(1)(A)(ii), assuming that the partnership manufactures Product in whole or in substantial part within the United States, A is required to account for its allocable share of partnership items (including income, gain, loss, and deduction), cost of goods sold, and gross receipts related to Product from the collaboration. In addition, A must determine those items from all other activities outside the collaboration. Once both these amounts are calculated, A may aggregate them to apportion deductions to DPGR and compute QPAI and DPAD.
As is clear from this CCA, the IRS will consider all facts and circumstances in determining whether a collaboration between two parties will be treated as a partnership. Taxpayers participating in collaborations that they do not wish to be treated as partnerships should review the terms of their collaboration in light of the CCA to ensure that they have not inadvertently created a partnership.
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.