CHAPTER 6 THE SUBCHAPTER K ELECTION: WHAT, WHEN, WHY AND HOW?
| Jurisdiction | United States |
(Mar-Apr 1977)
THE SUBCHAPTER K ELECTION: WHAT, WHEN, WHY AND HOW?
Vinson & Elkins
Houston, Texas
Subchapter K of the Internal Revenue Code of 1954 (sections 701 through 761)1 contains the statutory rules for taxation of partners and partnerships. Anyone who has tried to gain a working knowledge of these sections will readily agree that one of the most important questions about subchapter K is how one avoids it. Since 1954 section 761(a) of the Code has offered qualifying organizations that opportunity — total or partial exclusion from the application of subchapter K. The purpose of this paper is to discuss the types of organizations which are entitled to elect exclusion from subchapter K, the ramifications if they do so or fail to do so, the manner in which the election is made, and last, but certainly not least, special situations in which the election is, or is not, advisable.
BACKGROUND TO ENACTMENT OF SECTION 761(a) ELECTION
The term "partnership" as used in the Internal Revenue Code is considerably broader than that term as used under general common law principles. Section 761 defines a partnership as "including" —
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.2
As is obvious from the breadth of the definition and the use of the word "includes," the partnership is the catchall business tax entity. When two or more associates create an active business organization which does not constitute a corporation (or an association with sufficient corporate attributes to be taxed as a corporation), or the less likely entities of a trust or estate carrying on business, is taxable as a partnership.
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That does not mean that every noncorporate joint undertaking, or joint ownership of property, results in the creation of a partnership for federal income tax purposes. For example, the regulations under section 761 specifically state that a joint undertaking merely to share expenses is not a partnership, using as an illustration the joint construction of a ditch by two or more persons to drain surface water from their respective properties.3 Such arrangement does not make such persons partners, or the arrangement between them a partnership, for tax purposes. As to joint ownership of property, the regulations provide:
Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a partnership. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for a cash rental of a share of the crops, they do not necessarily create a partnership thereby.4
Such co-tenants or joint owners may however create a partnership for tax purposes if they go further and use the property to carry on a trade or business, or in the words of the regulations, "other financial operation or venture." Drawing the line between mere co-ownership of property with the attendant expenses of maintenance and repair, which does not constitute a partnership for tax purposes, and the use of jointly owned property in a trade or business, which does, has been extremely difficult for the courts and the Internal Revenue Service. The question has probably arisen most often in the context of mineral exploration and development ventures because of the unique relationship between co-owners of mineral properties who enter into an agreement for the joint exploration and development of their property.
Partnership and Joint Ventures Under State Law.
Entities which are classified as either partnerships or joint ventures under applicable state law are plainly partnerships under the Code. The Uniform Partnership Act, which has been adopted by all 50 states and the District of Columbia, defines a partnership as "an association of two or more persons to carry on as co-owners a business for profit."5 A joint venture is less precisely defined under the law of most states, but generally it is the label given to an entity which would constitute a partnership but for the fact that the contract creating the entity limits it to a particular project or undertaking. The distinction between a
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partnership and a joint venture lies only in the scope of the activity. As one author described it: "A joint venture is a variety of partnership, distinguishable only by vague considerations of scope, duration or continuity of business, all of which relate to matters of degree rather than to essential differences in kind."6 It seems clear, however, under the law of all states that an essential element of both a partnership and a joint venture is the carrying on of a business enterprise, not the mere co-ownership of property.
Classification of Agreements Among Mineral Co-owners.
When joint owners of a mineral deposit agree upon a method for the management and sharing of expenses of exploration, development and production of their commonly-owned asset it has not historically been clear whether the agreement constitutes a partnership (or joint venture) under state law.7 This uncertainty under applicable state law played a major role in the development of section 761(a).
The co-owners of a mineral property stand in an unusual, if not unique, position with respect to one another. In Texas, and in most oil producing states, a co-tenant can enter upon the property and mine or produce the mineral to prevent drainage from production of adjoining tracts.8 The co-owner so acting would be required to account to his co-tenants for their share of the profits, although he is entitled to a contribution from them for their proportion of his expenses. If his efforts are unsuccessful, he bears the entire risk of loss himself.
Where more than one mineral owner wishes to enter upon the tract to produce his share of the oil and gas, obvious difficulties would be encountered. Quite understandably, oil and gas operating agreements were developed whereby the co-owners would agree upon the method of sharing the costs of developing the mineral property and the operation of the property for the benefit of all of the co-owners. This concept is basically the same in the case of unitization agreements, but on a much larger scale with many leases and many more owners.
The method of operation under a standard operating agreement is for one party, who may or may not be a co-owner of the
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property, to operate the property as a common agent for all the co-owners and to have the oil sold and delivered to the pipeline company under division orders signed by each of the co-owners. The pipeline company remits payment directly to each of the co-owners for his proportionate share of production. The common agent, the operator, bills each co-owner for his proportionate share of expenses of operating the property.
Such arrangements have been difficult to classify under state law. They have been called "joint ventures", "joint adventures", and "mining partnerships", among other labels. They can arise by operation of law as well as by agreement. The two common characteristics of all such arrangements is common ownership of the mineral interest by the members (which ownership may take the form of a fee ownership, a mineral lease or other contract giving the holder the exclusive right to produce and own a specified portion of the minerals) and actual joint operation of the property by the co-owners. The usual characteristic of a partnership, choice of associates by the members, is absent in a joint operating agreement. A transferee of a co-working interest owner becomes a party to the agreement, and thus a participant in the organization, merely by becoming an owner of an interest in the property subject to joint operation. Death, withdrawal, bankruptcy, or assignment does not work a dissolution of the arrangement and the relationship continues among the parties who are co-owners following that event. As was early stated by the Supreme Court, "[t]he delectus personnae [choice of associates] which is essential to constitute an ordinary partnership, has no place in these mining associations."9 The special relationship created by operating agreements among co-owners of mineral properties has been described as arising out of necessity in the mining communities of the west where "lawyers were not particularly welcome."10
Attempts to classify the relationship as a joint venture or mining partnership on the one hand, or as a co-tenancy on the other, have been fraught with inconsistencies. One author states that "no matter what position is taken as to classification, there is some basis for such a position."11
For federal income tax purposes this lack of consistency in classification was reflected by confusion whether an operating
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agreement created an entity which should be treated as a partnership for federal tax purposes. In 1934 the Bureau of Internal Revenue in a very brief ruling found that the usual co-ownership of an oil and gas lease constituted a partnership.12 At the same time, the Bureau announced that such partnerships could file abbreviated partnership returns setting forth only certain revenues and expenditures.13
In 1948 the Bureau issued a detailed ruling addressed to the question whether an arrnagement for oil and gas operations would constitute an association taxable as a corporation.14 In setting forth the principles applicable to the association question, the ruling concluded that there was no joint profit motive where the parties had the right to take the jointly produced product in kind and dispose of it individually, since there would be no joint sale and division of net profits therefrom. This ruling illustrated the confusion with respect to classification of such arrangements by stating that if...
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