Inadvertent partnerships.

• Author: Colton, Gary S.

The existence, or nonexistence, of a partnership is not always easy to determine. Clients enter into informal arrangements and written "agreements" that can create partnerships without their knowledge. The Code allows for electing out of partnership treatment in certain situations and some agreements attempt to opt out of partnership treatment by specifically stating that they do not create a partnership. The existence of a partnership can make a substantial difference in how a client is taxed, as demonstrated by the following scenarios.

Case 1

Assume several taxpayers enter into a "participation agreement" under which they agree to contribute funds to a gold refiner who assigns them a "participating interest" in a contract to purchase and refine gold ore concentrate. The taxpayers are entitled to receive a certain percentage of the refined gold. Although the participation agreement is similar to a standard partnership agreement, it specifically states that it is not a partnership and that "the participants expressly elect to be excluded from the application of Subchapter K, Chapter 1, Subtitle A pursuant to the provisions of Sec. 761(a)(2)." Assume further that the gold refiner goes bankrupt and no partnership return is ever filed. The taxpayers lose their investment and deduct it on their tax returns as an ordinary loss. On audit, the IRS might disallow the deduction. The Service might take the position that the investment was either a loan or the purchase of a capital asset that became worthless, thus creating a capital loss. If the taxpayers were partners with the gold refiner, their loss could be characterized either as an ordinary loss from partnership operations or a Sec. 165 ordinary loss from the abandonment of a worthless partnership interest. (Assume Sec. 752 is not a problem since there were no partnership liabilities; see Echols, 5th Cir., 1991.) Will the written agreement not be treated as a partnership control?

Sec. 761 can be used by unincorporated organizations that are "availed of ... for the joint production, extraction, or use of property . . . ." However, a valid election under Sec. 761 is not made in an agreement between the parties involved. An organization must file Form 1065, U.S. Partnership Return of Income, for the first tax year for which it wishes to be excluded, complete with the information required by Regs. Sec. 1.761-2(b)(2)(i). Since no return had been filed, there was no election out of subchapter K, but...