Exclusion From Partnership Rules
Certain partnerships that do not actively conduct a business can
choose to be completely or partially excluded from being treated as partnerships
for federal income tax purposes. All the partners must agree to make the choice, and the
partners must be able to compute their own taxable income without computing the
partnership's income. However, the partners are not exempt from the rule that limits a
partner's distributive share of partnership loss to the adjusted basis of the partner's
partnership interest. Nor are they exempt from the requirement of a business purpose for
adopting a tax year for the partnership that differs from its required tax year, discussed
under Tax Year, later.
Investing partnership. An investing partnership can be excluded if
the participants in the joint purchase, retention, sale, or exchange of investment
property meet all the following requirements.
- They own the property as co-owners.
- They reserve the right separately to take or dispose of their shares of any property
acquired or retained.
- They do not actively conduct business or irrevocably authorize some person acting in a
representative capacity to purchase, sell, or exchange the investment property. Each
separate participant can delegate authority to purchase, sell, or exchange his or her
share of the investment property for the time being for his or her account, but not for a
period of more than a year.
Operating agreement partnership. An operating agreement partnership
group can be excluded if the participants in the joint production, extraction, or use of
property meet all the following requirements.
- They own the property as co-owners, either in fee or under lease or other form of
contract granting exclusive operating rights.
- They reserve the right separately to take in kind or dispose of their shares of any
property produced, extracted, or used.
- They do not jointly sell services or the property produced or extracted. Each separate
participant can delegate authority to sell his or her share of the property produced or
extracted for the time being for his or her account, but not for a period of time in
excess of the minimum needs of the industry, and in no event for more than one year.
However, this exclusion does not apply to an unincorporated organization one of whose
principal purposes is cycling, manufacturing, or processing for persons who are not
members of the organization.
Electing the exclusion. An eligible organization that wishes to be
excluded from the partnership rules must make the election not later than the time for
filing the partnership return for the first tax year for which exclusion is desired. This
filing date includes any extension of time. See section 1.761-2(b) of the regulations for
the procedures to follow.
Tax Year
Taxable income is figured on the basis of a tax year. A tax
year is the accounting period used for keeping records and reporting income and
expenses.
Partnership. A partnership determines its tax year as if it were a
taxpayer. However, there are limits on the year it can choose. In general, a partnership
must use its required tax year. A required tax year is a tax year that is required under
the Internal Revenue Code and Income Tax Regulations. For a partnership, the required tax
year is the tax year determined under section 706 of the Internal Revenue Code and section
1.706 of the regulations. See Required Tax Year, later. Exceptions to this rule
are discussed under Exceptions to Required Tax Year, later.
Partners. Partners can change
their tax year only if they receive permission from the IRS. This also applies to
corporate partners, who are usually allowed to change their accounting periods without
prior approval if they meet certain conditions.
Closing of tax year. Generally, the partnership's tax year is not
closed because of the sale, exchange, or liquidation of a partner's interest, the death of
a partner, or the entry of a new partner. However, if a partner sells, exchanges, or
liquidates his or her entire interest, or a partner dies, the partnership's tax year is
closed for that partner. See Distributive share in year of disposition under Partner's
Income or Loss, later.
Required Tax Year
A partnership generally must conform its tax year to its partners' tax
years. The rules for determining the required tax year are as follows.
- Majority interest tax year. If one or more partners having the same tax
year own an interest in partnership profits and capital of more than 50% (a majority
interest), the partnership must use the tax year of those partners.
Testing day.
The partnership determines if there is a majority interest tax year on the
testing day, which is usually the first day of the partnership's current tax year.
Change in tax year. If a partnership's majority interest tax year
changes, it will not be required to change to another tax year for 2 years following the
year of change.
- Principal partner. If there is no majority
interest tax year, the partnership must use the tax year of all its principal partners. A
principal partner is one who has a 5% or more interest in the profits or capital of the
partnership.
- Least aggregate deferral of income. If there is no majority interest tax
year and the principal partners do not have the same tax year, the partnership generally
must use a tax year that results in the least aggregate deferral of income to the
partners.
Least aggregate deferral of income. The tax year that results in the
least aggregate deferral of income is determined as follows.
- Figure the number of months of deferral for each partner using one partner's tax year.
Count the months from the end of that tax year forward to the end of each other partner's
tax year.
- Multiply each partner's months of deferral figured in step (1) by that partner's
interest in the partnership profits for the year used in step (1).
- Add the results in step (2) to get the total deferral for the tax year used in step (1).
- Repeat steps (1) through (3) for each partner's tax year that is different from the
other partners' years.
The partner's tax year that results in the lowest total number in step (3) is the tax
year that must be used by the partnership. If the calculation results in more than one
year qualifying as the tax year that has the least aggregate deferral, the partnership can
choose any one of those tax years as its tax year. However, if one of the years that
qualifies is the partnership's existing tax year, the partnership must retain that tax
year.
Example. Rose and Irene each have a 50% interest in a
partnership that uses a fiscal year ending June 30. Rose uses a calendar year while Irene
has a fiscal year ending November 30. The partnership must change its tax year to a fiscal
year ending November 30 because this results in the least aggregate deferral of income to
the partners. This was determined as shown in the following table.
| Year End 12/31: |
Year End |
Profits Interest |
Months of Deferral |
Interest × Deferral |
| Rose |
12/31 |
0.5 |
-0- |
-0- |
| Irene |
11/30 |
0.5 |
11 |
5.5 |
| Total Deferral |
5.5 |
| Year End 11/30: |
Year End |
Profits Interest |
Months of Deferral |
Interest × Deferral |
| Rose |
12/31 |
0.5 |
1 |
0.5 |
| Irene |
11/30 |
0.5 |
-0- |
-0- |
| Total Deferral |
0.5 |
Special de minimis rule. If the tax year that results in
the least aggregate deferral produces an aggregate deferral that is less than 0.5 when
compared to the aggregate deferral of the current tax year, the partnership's current tax
year is treated as the tax year with the least aggregate deferral.
When determination is made. Generally, determination of the
partnership's required tax year under the least aggregate deferral rules is made at the
beginning of the partnership's current tax year. However, the IRS can require the
partnership to use another day or period that will more accurately reflect the ownership
of the partnership.
Procedures. A partnership can get an automatic approval to change to
a required tax year by filing Form 1128 with the Service Center where it files its federal
income tax returns. The partnership should write FILED UNDER REV. PROC. 2002-38
at the top of page 1 of Form 1128 and file it by the due date (including extensions) for
filing the short period tax return.
Short period return. When
a partnership changes its tax year, a short period return must be filed. The short
period return covers the months between the end of the partnership's prior tax year and
the beginning of its new tax year.
If a partnership changes to the tax year resulting in the least aggregate deferral, it
must file a Form 1128 with the short period return showing the computations used to
determine that tax year. The Form 1128 should also be attached to the partnership tax
return. The short period return must indicate at the top of page 1, FILED UNDER
SECTION 1.706-1.
Exceptions to Required
Tax Year
There are certain exceptions to the required tax year rule.
Business purpose tax year. If a
partnership establishes an acceptable business purpose for having a tax year different
from its required tax year, the different tax year can be used. Administrative and
convenience business reasons such as the deferral of income to the partners are not
sufficient to establish a business purpose for a particular tax year.
See Business Purpose Tax Year in Publication 538 for more information.
Section 444 election. A
partnership can elect under section 444 of the Internal Revenue Code to use a tax year
different from its required tax year. Certain restrictions apply to this election.
In addition, the electing partnership may be required to make a payment representing the
value of the extra tax deferral to the partners.
See Section 444 Election in Publication 538 for more information.
52-53-week tax year. A partnership can use a tax year other than its
required tax year if it elects a 52-53-week tax year that ends with reference to its
required tax year or a tax year elected under section 444 (discussed earlier). See 52-53-Week
Tax Year under Fiscal Year in Publication 538 for information on the
52-53-week tax year.
Partnership Return
(Form 1065)
Every partnership that engages in a trade or business or has gross income must file an
information return on Form 1065 showing its income, deductions, and other required
information. The partnership return must show the names and addresses of each partner and
each partner's distributive share of taxable income. The return must be signed by a
general partner. If a limited liability company is treated as a partnership, it must file
Form 1065 and one of its members must sign the return.
A partnership is not considered to engage in a trade or business, and is not required
to file a Form 1065, for any tax year in which it neither receives income nor pays or
incurs any expenses treated as deductions or credits for federal income tax purposes.
See the instructions for Form 1065 for more information about who must file Form 1065.
Due date. Form 1065 generally
must be filed by April 15 following the close of the partnership's tax year if its
accounting period is the calendar year. A fiscal year partnership generally must
file its return by the 15th day of the 4th month following the close of its fiscal year.
If a partnership needs more time to file its return, it should file Form 8736 by
the regular due date of its Form 1065. The automatic extension is 3 months.
If the partnership has made a section 444 election to use a tax year other than a
required year, an automatic extension of time for filing a return will run concurrently
with any extension of time allowed by the section 444 election. The filing of an
application for extension does not extend the time for filing a partner's personal income
tax return or for paying any tax due on a partner's personal income tax return.
If the due date for filing a return falls on a Saturday, Sunday, or legal holiday, the
due date is extended to the next business day.
Schedule K-1 due to partners. The
partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date
Form 1065 is required to be filed, including extensions.
Penalties
To help ensure that returns are filed correctly and on time, the law provides penalties
for failure to do so.
Failure to file. A penalty is
assessed against any partnership that must file a partnership return and fails to file on
time, including extensions, or fails to file a return with all the information
required. The penalty is $50 times the total number of partners in the partnership during
any part of the tax year for each month (or part of a month) the return is late or
incomplete, up to 5 months.
The penalty will not be imposed if the partnership can show reasonable cause for its
failure to file a complete or timely return. Certain small partnerships (with 10 or fewer
partners) meet this reasonable cause test if:
- All partners are individuals (other than nonresident aliens), estates, or C
corporations,
- All partners have timely filed income tax returns fully reporting their shares of the
partnership's income, deductions, and credits, and
- The partnership has not elected to be subject to the rules for consolidated audit
proceedings (explained later under Partner's Income or Loss, in the discussion
under Reporting Distributive Share).
The failure to file penalty is assessed against the partnership. However, each partner
is individually liable for the penalty to the extent the partner is liable for partnership
debts in general.
If the partnership wants to contest the penalty, it must pay the penalty and sue for
refund in a U.S. District Court or the U.S. Court of Federal Claims.
Failure to furnish copies to the partners. The partnership must furnish copies of Schedule K-1 (Form 1065) to the
partners. A penalty for each statement not furnished will be assessed against the
partnership unless the failure to do so is due to reasonable cause and not willful
neglect.
Trust fund recovery penalty. A
person responsible for withholding, accounting for, or depositing or paying withholding
taxes who willfully fails to do so can be held liable for a penalty equal to the
tax not paid.
Willfully in this case means voluntarily, consciously, and intentionally.
Paying other expenses of the business instead of the taxes due is considered willful
behavior.
A responsible person can be a partner, an employee of the partnership, or an
accountant. This may also include someone who signs checks for the partnership or
otherwise has authority to cause the spending of partnership funds.
Other penalties. Criminal
penalties can be imposed for willful failure to file, tax evasion, or making a false
statement.
Other penalties can be imposed for the following actions.
- Not supplying a taxpayer identification number.
- Not furnishing information returns.
- Underpaying tax due to a valuation misstatement.
- Not furnishing information on tax shelters.
- Promoting abusive tax shelters.
However, certain penalties may not be imposed if there is reasonable cause for
noncompliance.
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