CHAPTER 5 PARTNERSHIPS AND NON PARTNERSHIPS TAX PITFALLS AND SAFE HARBORS

• Jurisdiction: United States

Mineral Taxation
(Mar-Apr 1977)
CHAPTER 5
PARTNERSHIPS AND NON PARTNERSHIPS TAX PITFALLS AND SAFE HARBORS
Burke W. Willsey
Musick, Peeler & Garrett
Los Angeles, California

Introduction

The use of the partnership-type of arrangement for carrying on mineral exploitation far predates the modern income tax law. Perhaps the most familiar example is one which is engrained in the folk lore of the west; the grizzled prospector who made a deal with a provisioner to supply him with a "grubstake". In return, if the prospector made a find, he would agree to pay part of his profit to the supplier.¹ From relatively humble beginnings of this general type have arisen the present-day joint venture arrangements, cost company relationships, and complex partnerships which supply the manufacturing needs of modern technology with the raw materials necessary to support our Nation's current high standard of living.

No matter how complex these arrangements become, however, they almost always result from the same basic concerns that prompted the grubstake arrangements; one party owns a property or has the technical expertise necessary to find and develop a mineral deposit, while another party has the capital resources to finance that development. Of course, in some instances, the present-day miner may have the financial resources necessary to find and develop the deposit, but wishes to have another share in the risk. Also, another party may want to participate in the venture because of a need for the raw material to be produced by the operation. In almost all situations, however, the basic needs of financing the location and the development of the project have provided the impetus for the affiliation of more than one person in the mineral venture.

As with all forms of business operations, increasing monetary need has prompted the presence of the Government as an uninvited partner, which has been reflected in the increasing burden of taxation. As an interested and active participant in the development of the tax law, this partner also has had a profound impact on the form business ventures have taken in the minerals area. Although an understanding of the developing tax law itself is important, a familiarity with the background of the industry and the business needs that have given birth to these various forms of business enterprise is very helpful in

[Page 5-2]

placing the tax consequences of those activities in their proper perspective.

In this regard, taxpayers and their advisers must also be constantly alert to changes in the philosophical attitude of the Internal Revenue Service as it administers the tax laws. A great deal of the current tax law applicable to mineral operations is based upon administrative practice or Court decisions, rather than specific provisions in the Internal Revenue Code and the Income Tax Regulations promulgated under that Code.² Consequently, drastic changes can be effected as a result of subtle shifts in nuances of administrative interpretation of the law. In the general area of taxation of natural resources, perhaps more than in any other area of tax law, a real body of common law has developed, some of which may not even be contained in published Rulings. As with any area of common law development, one can never be entirely certain that today's generally accepted principles will not be tomorrows interesting historical sidelights, no longer having a direct bearing on the taxation of the industry.

The recent events relating to the so-called cost companies provide an illustrative case history of this point and will be developed in more detail later in this paper.³ Without any particular showing of tax abuse, the Service has announced that these companies, which had historically been treated as partnerships, would no longer be so treated.⁴ An administrative development of this type is particularly disconcerting to taxpayers who must continue to operate in an industry where, as noted above, so much of the accepted tax law is based upon administrative practice.

With this strong warning in mind, that what may appear to be a partnership on one day may be something entirely different the next day, an examination of the more easily recognized problems of partnerships in the mining industry takes on additional intrigue, if not poignancy.

Classification as a Partnership

Under the broad sweep of subchapter K of the Code, any "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 subtitle, a corporation or a trust or estate"⁵ is a partnership. Thus, almost every form of carrying on a mining operation by two or more persons (other than through a corporation, trust or estate) can be classified as a partnership. Consequently, the parties can consciously

[Page 5-3]

decide to enter into a formal partnership and execute the normal type of partnership agreement, or they may merely decide to operate a property jointly and still be considered a partnership for tax purposes. Although this broad provision can cause problems, it also provides maximum flexibility in choosing an appropriate form for carrying on the business.

Mineral ventures can be operated as a corporation, a trust, a small business corporation under Subchapter S of the Code, a partnership, a limited partnership, or a co-ownership that elects not to be treated as a partnership. Of course, it may also be possible that a straightforward lease and royalty arrangement meets the needs of the parties. In view of this breadth of opportunity, any time two or more persons undertake any kind of joint participation in exploring for, developing, or producing from a mineral deposit, careful consideration must be given to identifying the proper tax classification of the resulting enterprise.

In general, it frequently is desirable to have the new business entity classified as a partnership. The partnership itself is not subject to tax, and the partners themselves report all items of income and deductions. Thus, the income is taxed only once and the partners take their share of the deductions directly. At the other end of the spectrum, parties entering into a joint arrangement with the expectation of being classified as a partnership must be careful not to fall afoul of being classified as an association taxable as a corporation, which would generally mean the income would be subject to a double tax — once at the association (corporate) level, and again when distributed to the association members (shareholders). Also, any deductions would be available only to the association (corporation). If the parties wish to use the corporate form and still have the general advantages of partnership tax treatment, it is possible to use the so-called subchapter S corporation.⁶ This form of business entity has very specific requirements that must be strictly complied with. The first of the real pitfalls in partnership taxation must be faced in making certain that the entity is a partnership.

Under the present Regulations, six major characteristics are used to identify corporations and distinguish them from other forms of doing business: (1) associates; (2) an objective to carry on a business and divide the profits therefrom; (3) continuity of life; (4) centralization of management; (5) limited liability; and (6) free transferability of interests.⁷ In distinguishing between two forms of business entity, the Regulations treat characteristics that exist in both entities as neutral. Therefore, because the first two characteristics are present in

[Page 5-4]

both corporations and partnerships, only the last four are considered. In order to be classified as a corporation under these rules, an enterprise must have more corporate characteristics than partnership characteristics. Consequently, most types of arrangements in which the parties want to be treated as a partnership will qualify because they will lack continuity of life (they usually terminate on a specific date or on the death or dissolution of a partner) and free transferability of interests (the partner usually cannot convey his interest without the agreement of the other partner). In addition, most arrangements will not have limited liability because each partner will be completely liable for the debts and obligations of the partnership. Also, there may not be centralized management if both parties are actively involved in the business.

In any particular deal, however, the parties may wish to include a provision that will have the effect of bringing one or more of the corporate characteristics into play. The cumulative effect of such provisions can be disastrous. For example, if one party is to be operator, centralized management comes in. If both parties want to be free to transfer their interests, and so provide in the agreement, free transferability comes in. A provision in the agreement that has the effect of continuing the arrangement for an unlimited life, and suddenly an association taxable as a corporation is born.

The potential for such a situation is graphically illustrated in the tax shelter deals that became so...