Organizations Classified — 1225 Publ 541 (PDF)

An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996.

Organizations formed after 1996. An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following.

An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic.
An organization formed under a state law that refers to it as a joint-stock company or joint-stock association.
An insurance company.
Certain banks.

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537

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334 Tax Guide for Small Business

505 Tax Withholding and Estimated Tax

515 Withholding of Tax on Nonresident Aliens and Foreign Entities

537 Installment Sales

538 Accounting Periods and Methods

544 Sales and Other Dispositions of Assets

551 Basis of Assets

925 Passive Activity and At-Risk Rules

946 How To Depreciate Property

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An organization wholly owned by a state, local, or foreign government.
An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships).
Certain foreign organizations identified in Regulations section 301.7701-2(b)(8).
A tax-exempt organization.
A real estate investment trust (REIT).
An organization classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.
Any other organization that elects to be classified as a corporation by filing Form 8832.

For more information, see the instructions for Form 8832.

Limited liability company (LLC). An LLC is an entity formed under state law by filing articles of organization as an LLC. Unlike a partnership, none of the members of an LLC are personally liable for its debts. However, if the LLC is an employer, an LLC member may be liable for employer-related penalties. See Pub. 15, (Circular E), Employer’s Tax Guide, and Pub. 3402, Taxation of Limited Liability Companies. An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301.7701-3. See Form 8832 and Regulations section 301.7701-3 for more details.

Tip: A domestic LLC with at least two members that doesn’t file Form 8832 is classified as a partnership for federal income tax purposes.

Organizations formed before 1997. An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and doesn’t elect to be classified as a corporation by filing Form 8832.

Community property. Spouses who own a qualified entity (defined below) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. They can choose to classify the entity as a sole proprietorship by filing a Schedule C (Form 1040), Profit or Loss From Business, listing one spouse as the sole proprietor. A change in reporting position will be treated for federal tax purposes as a conversion of the entity.

A qualified entity is a business entity that meets all the following requirements.

The business entity is wholly owned by spouses as community property under the laws of a state, a foreign country, or a possession of the United States.
No person other than one or both spouses would be considered an owner for federal tax purposes.
The business entity is not treated as a corporation.

For more information about community property, see Pub. 555, Community Property. Pub. 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Partnership Interests Created by Gift

Gift of capital interest. If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee’s distributive share of partnership income is subject to both of the following restrictions.

It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership.
The donee’s distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor’s distributive share attributable to the donor’s capital.

Purchase considered gift. For purposes of determining a partner’s distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. The FMV of the purchased interest is considered donated capital. For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons).

Partnership Interests Held in Connection With Performance of Services

Section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. The provision generally requires that a capital asset be held for more than 3 years for capital gain and loss allocated with respect to any applicable partnership interest (API) to be treated as long-term capital gain or loss. Proposed Regulations ( REG-107213-18 ) were published in the Federal Register on August 14, 2020. Final regulations (Treasury Decision 9945) were published in the Federal Register on January 19, 2021. Treasury Decision 9945, 2021-5 I.R.B. 627, is available at IRS.gov/irb/2021-5_IRB#TD-9945 . Owner taxpayers and pass-through entities may rely on the proposed regulations for tax years beginning before January 19, 2021 (the date final regulations were published in the Federal Register), provided they follow the proposed regulations in their entirety and in a consistent manner. An owner taxpayer or pass-through entity may choose to apply the final regulations to a tax year beginning after December 31, 2017, provided that they consistently apply the final section 1061 regulations in their entirety to that year and all subsequent years. Owner taxpayers and pass-through entities must apply the final regulations to tax years beginning on or after January 19, 2021. See Section 1061 Reporting Instructions , later.

Applicable partnership interest (API). An API is any interest in a partnership that, directly or indirectly, is

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transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business. The special recharacterization rule applies to:

Capital gains recognized by a partner from the sale or exchange of an API under sections 741(a) and 731(a); and
Capital gains recognized by a partnership, allocated to a partner with respect to an API.

Applicable trade or business. An “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis (regardless of whether the activity is conducted through one or more entities) which consists in whole or in part of raising and returning capital, and either:

Investing in or disposing of “specific assets” (or identifying specified assets for investing or disposition), or
Developing specified assets.

Specified assets. Specified assets are:

Securities (as defined in section 475(c)(2), under rules for mark-to-market accounting for securities dealers);
Commodities (as defined under rules for mark-to-market accounting for commodities dealers in section 475(e)(2));
Real estate held for rental or investment;
Options or derivative contracts with respect to such securities;
Cash or cash equivalents; or
An interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.

Security. A “security” for this purpose means any of the following.

Share of corporate stock.
Partnership interest or beneficial ownership interest in a widely held or publicly traded partnership or trust.
Note, bond, debenture, or other evidence of indebtedness.
Interest rate, currency, or equity notional principal contract.
Interest in or derivative financial instrument in any such security or any currency (regardless of whether section 1256 applies to the contract).
Position that is not such a security and is a hedge with respect to such a security and is clearly identified.

Business Owned and Operated by Spouses

If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a Schedule C

(Form 1040) in the name of one spouse as a sole proprietor. However, the spouses can elect not to treat the joint venture as a partnership by making a qualified joint venture election.

Qualified Joint Venture Election

A qualified joint venture, whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. A qualified joint venture conducts a trade or business where the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or an LLC.

Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore doesn’t have a Form 1065 filing requirement. All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. Each spouse takes into account their respective share of these items as a sole proprietor. Each spouse would account for their respective share on the appropriate form, such as Schedule C (Form 1040). For purposes of determining net earnings from self-employment, each spouse’s share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes (that is, based on their respective interests in the venture).

If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry their share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. Each spouse should include their respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax.

This generally doesn’t increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. However, this may not be true if either spouse exceeds the social security tax limitation.

For more information on qualified joint ventures, go to IRS.gov/QJV .