What is a Partnership Status For Tax Purposes

Partnership Status For Tax Purposes

Ronald Smith and his son, Paul, had a fairly substantial agricultural operation in Miami.  They chose to report their accounting arrangement as separate businesses instead as a Partnership Status For Tax Purposes.  All income and expenses were reported on one tax return or the other.  The thing that probably bothered the IRS more than anything else was that although the income was divided 50/50, the expenses were disproportionately allocated to Ronald.  Ronald, and accountant, had significant income from his accounting service, while day to day operation of the farm were handled by Paul.  In order to avoid being whipsawed the IRS took a rather draconian approach in its notice of deficiency. It taxed each of them on 100% of the income and denied all the deductions.  Over the three years in question the operation produced about $80,000 in taxable income, which had been reported.  The deficiency notices totalled over $1,000,000 in tax.

The ultimate decision by the Tax Court was that the arrangement was a Partnership Status For Tax Purposes and, lacking anything better to go on, net income should have been divided 50/50, which presumably was the result the IRS was aiming for when it issued the overblown deficiency notices.  The Ninth Circuit just upheld the Tax Court decision.  The Ninth Circuit decision does not include much detail and I would have glossed over it had I not written about the Tax Court decision, which tells a rather fascinating story.  Some Tax Court decisions are more interesting than most novels.

There is an important practice point in this case.  Mr. Smith created a lot of trouble for himself by treating his arrangement with his son as two separate businesses instead of a Partnership Status For Tax Purposes. I have a hard time seeing what he was gaining.  Assuming the expense allocation was reflective of how they would ultimately split the money, the bottom line effect that it had could have been achieved with a well drafted partnership agreement.  Instead he ended up with a nightmare.  I look at it as a cautionary tale.

Partnership For Tax Purposes?

When two or more people ally in profit making activities, they might account for those activities as separate businesses and, if individuals, report them on Schedule C or page 1 of Schedule E.  Alternatively, they might file a partnership return.  In that case an extra return is filed (i.e. Form 1065) and K-1s are issued to the partners.  Each partner reports a share of the partnership taxable income on page 2 of Schedule E.  Despite what many people think, this is not something that is a matter of free choice, except in special circumstances.  In principle, a accountant should analyze the arrangement between the parties and determine whether or not the arrangement is a partnership for income tax purposes (What the individuals call the arrangement is only one of the factors to consider and probably not one of the more important ones).  The problem is that in applying accounting and tax laws to facts on this question you will find a fairly large gray area, particularly when you are dealing with people who do business on a handshake (or maybe a wink and a nod).  Fuzzy law applied to fuzzy facts makes for lots of fuzz.

Why Should Anybody Care?

Imagine a parent, probably a father, who puts the cheerios in front of the little kid and pours in the orange juice.  The little kid already upset about several other deviations from the smooth running household machine that temporarily absent Mom maintains will likely complain.  The answer to the complaint is something that is genetically implanted in the mind of male parents.  “It’s all going to the same place anyway.  Eat it.”  You could look at the separate businesses versus partnership issue the same way.  It all ends up in the accounting of the adjusted gross income of the individuals, so why worry about it?

It does make a difference.  Even though a partnership does not pay tax, it is a “taxpayer”.  It has its own accounting method and a variety of determinations are made at the partnership level.  An interest in a partnership, unlike a co-ownership interest in an asset, such as real estate, cannot be the subject of a like-kind exchange.  If you think you had a couple of separate businesses and it turns out that you really had a partnership you can end up with a pretty ugly mess, which is what happened to the Smiths.

When In Doubt Accountant Should File As Partnership?

If you have an arrangement that might be viewed as a partnership, the safer course is probably to get a partnership agreement drafted or more likely form an LLC and have an operating agreement drafted.  Then file as a partnership.  It is a complex area but the tip off to your arrangement being a partnership is that you are carrying on business and dividing profits. If the arrangement is substantial and there are compelling business or tax reasons to avoid partnership status you will probably need even more complicated agreements.  Ironically the best person to draft them for you is probably a tax attorney who is an expert on partnerships.



Shaping Up Your Accounting Firms in Miami

Have you thought about what you can do in your Accounting Firms in Miami to improve how you operate your business, making sure that this year is a better year than last year? Do you think your firm needs improved focus in order to be more profitable? Please allow me to offer some suggestions that could streamline your business to a “leaner and meaner” more profitable machine.

1. Clean Out the Closet

Have you had an experience like I have, going into a closet or a desk drawer and finding it so cluttered with “stuff” that you couldn’t find what you were looking for? Everything you put in that closet or drawer had a purpose at the time, but it turned out you never used it, and it most likely could have been thrown away in the first place. But, like me, you held on to it thinking someday it would be useful.

Our book of clients can sometimes get like that proverbial closet or drawer. All of us have what we would term “marginal” clients – those who probably don’t consider you their primary Accounting Firms in Miami, don’t totally value your advice, and maybe don’t even completely trust you. Yet, they can take up a sizeable amount of your time with little profitability to show for it.

Maybe it’s time to clean out your book in order to make room for profitable clients. Consider referring them to another Accounting Firms in Miami. Or, if you have a large number of them, consider segmenting that block of business and selling it to another CPA Firm – perhaps a younger accountant just getting started in the business, for whom those clients would be valuable.

This is a hard thing to do for many CPA’s, but, in the end, both you and those clients will benefit. You will benefit in that you will be able to structure your book with more profitable clients. The clients will benefit by being referred to an accountant who can and will spend more time with them to help them with their problems.

2. Build a Financial Planning Practice, Not an Asset Management Practice

In my experience, when I helped my clients with their accounting goals the business plan part of the process was not a major focus, yet, I continued to gather more and more assets under management. Many experts will tell you that if you fail to help your clients address the important accounting and tax issues, you will eventually lose the client, no matter how good an accountant you are.

3. Concentrate Your Efforts on Things Most Valuable to You and Your Clients

The best way for most of our clients to increase their net worth over a long period of time is to have a well-defined tax plan and to implement it. Having a purpose for every accounting decision will help our clients remain focused on their goals and how to get there. I heard an interesting statement recently. The speaker said that, in building a comfortable retirement nest egg, the just the decision to contribute to a 401(k)  was more important than how those investments are allocated. It sounds pretty simple, but how many individuals go for years without even contributing to their 401(k)? Educate your clients on the need to start investing for retirement (and other goals) as early as possible, and as much as possible. Statistics will show that this is a much more important decision than what to invest in.

Once they begin investing and understand why they are investing, then the investment and asset allocation decisions will follow. And, while asset allocation decisions are critical to the success of the investment process, an understanding of why they are investing is critical to their steadfastness with the process during both good and bad times. Dalbar’s Qualitative Analysis of Investor Behavior, which has measured the buy and sell behavior of individual investors since 1994, shows that the average individual investor almost always trails the S&P 400 index, according to Steven M. Sears, author of The Indomitable Investor. The primary reason, Sears said, is they don’t hold stocks long enough. This is a result of the erratic way individuals invest when they don’t have a defined plan or strategy.

4. Spend Less Time on Selection and Timing

My experience is that most Accounting Firms in Miami cannot consistently “outperform” the markets by researching individual stocks or funds, following trends or economic statistics, or using one of many techniques. Most of us cannot add a tremendous amount of value over that of professional money managers or a properly diversified portfolio, so why waste time trying? Spend that valuable time on more productive activities, such as time with clients identifying their goals, developing a plan of action to reach those goals, and then implementing and staying with the plan.

5. Move More of Your Accounting Service to a Fee-Based Model

If you are going to build an efficient business model similar to what I have outlined here, a fee-based compensation approach is the best practice, both for you and your client. Your clients want good advice and personal time with you to discuss issues and their plan, and they will be willing and happy to pay you for that service in the form of a financial planning or asset management fee. Everybody’s life is made simpler with such a model.