What is a Partnership: State Law vs. Federal Tax Law

Published Categorized as Business Tax, Partnership Tax, Tax
partnership vs. no partnership

One of the nuances that come up in tax planning involves the interplay of state law and federal tax law. This brings in all of the nuances and challenges under state law to federal tax law.

For example, one common nuance in business transactions arises when the parties to a business arrangement do not document the arrangement upfront. When disputes arise, it often results in litigation in state court to determine whether the arrangement is a partnership and whether the parties are entitled to a share of the assets upon liquidation of the business or departure from the business.

This type of dispute can be even more complex as the parties may point to how they reported the arrangement for federal tax purposes. This is particularly true now that we have the Partnership BBA rules to contend with (and the need to elect out). Regardless of whether it was or was not reported as a partnership for federal tax purposes, that may not determine the outcome in the state law dispute. The reverse is also true. The Galyean v. Guinn, Civil Action 4:21-CV-1287-BJ (N.D. Tex. Nov. 17, 2023) case provides an opportunity to consider this type of situation.

Facts & Procedural History

This is not a court case that addresses federal tax law and, as far as we know, there was no IRS audit. It involves Texas law and questions as to whether an arrangement counts as a partnership under Texas law.

In October 2021, cutting horse trainer Galyean sued Guinn, a businessman involved in the cutting horse industry, in Texas state court. Galyean alleged the parties had entered into an oral partnership agreement between 2015-2017 regarding two stallions, Metallic Rebel and Rollz Royce.

According to Galyean, the purpose of the partnership was to build a brand of horses capable of earning high breeding fees. Under the alleged terms, Galyean would manage and care for the horses, contribute money and property, ride them professionally, and receive reimbursement for costs, 50% of prize money, and 25% of breeding profits. So Galyean, the rider, had a lesser interest than Guinn, the investor.

In addition to not having a written partnership agreement, the parties did not report the arrangement as a partnership for federal tax purposes. Gaylean was paid 25% of breeding fees and reported them as “breeding season commission income” on his tax returns. He did not report them as partnership distributions.

In the litigation, Guinn denied the existence of any partnership agreement. In July 2021, he had removed the two stallions from Galyean’s ranch. After removal to federal court, a jury trial was held in July 2023. The jury found an oral partnership agreement existed under Texas law with the terms alleged by Galyean.

However, the court held the oral partnership agreement was unenforceable under the statute of frauds because its purpose could not be accomplished within one year. As a result, the court entered judgment in favor of Guinn despite the jury’s state law partnership finding.

What is a Partnership for Tax Purposes?

A partnership for tax purposes refers to a legal arrangement where two or more individuals or entities conduct business together with the intention of making a profit.

The formation and structure of a partnership are primarily governed by state law. Each state in the U.S. has its own laws and regulations regarding how partnerships are to be formed, operated, and dissolved. Once a partnership is established under state law, it becomes subject to federal income tax laws. This creates a two-step analysis, i.e., start with state law and then consider federal law.

But here is the tricky part: failing to meet state law criteria for partnership formation does not automatically preclude a business arrangement from being treated as a partnership for federal tax purposes. The courts have adopted a factor analysis to determine whether a business arrangement is a partnership for federal tax purposes.

The Culbertson Partnership Factors

The leading court case often cited in determining what constitutes a partnership for federal tax purposes is Commissioner v. Culbertson, 337 U.S. 733 (1949). This landmark Supreme Court decision has been pivotal in establishing the criteria for defining a partnership in the context of U.S. tax law.

In Culbertson, the Supreme Court established a “facts and circumstances” test. This test involves examining various aspects of the relationship, such as the agreement between the parties, the conduct of the parties in executing the terms of the agreement, the contributions made by each party, and the control and management of the business. The factors focus on the intent of the parties involved and their actual conduct in the business operation to determine whether a partnership exists.

Given these factors, the test of a partnership is whether the parties in question genuinely intended to join together for the purpose of carrying on a business and sharing in the profits or losses or both. The formal title or label given to the agreement is not controlling.

Conflicting State Law vs. Tax Law

As odd as it sounds, this can result in an arrangement not counting as a partnership for state purposes, but counting as a partnership for federal tax purposes. The Galyean case is an example of this.

In Galyean, a jury found that an oral partnership existed between Galyean and Guinn under Texas partnership law. The court did not agree. It held the oral agreement was unenforceable under the statute of frauds because it could not be completed within one year. As a result, no valid state law partnership existed that could be enforced.

However, if the IRS were to audit Galyean and Guinn’s tax returns, it could potentially find that a partnership existed for federal tax purposes under the Culbertson factors. The evidence presented at trial regarding the parties’ intent, respective contributions, sharing of revenue, and joint operations could support finding a partnership despite the lack of an enforceable agreement under state law.

This highlights the disconnect that can occur between partnerships under state law versus federal tax law. The definitions are not identical. Parties must carefully consider both sets of laws when documenting their business relationships to avoid adverse outcomes. This shows that failing to formalize an agreement that would qualify as a tax partnership can lead to unintended tax consequences even if no valid state-law partnership exists.

Why Might the IRS and Taxpayers Care?

You may be wondering why the IRS or the taxpayers would care how this is reported for federal tax purposes. There are several reasons that could come into play. For example:

  1. Partnerships require separate tax returns creating additional compliance obligations (and possible late filing penalties).
  2. Partnership treatment opens up the possibility of an audit adjustment being pushed down to the partners individually.
  3. The lack of required formalities for federal tax partnerships creates ambiguity if audited.

For example, a partnership has to report items of income and expense on its own income tax return at the entity level, and then report the allocable portion of the items of income and expense to the partners. This is not always equal. And the tax consequences to the individual partners vary based on their contributions to the partnership.

So in a situation like the one in this case, it may be that an investor put in the money and the service provider did not. The investor would be entitled to the tax-free return of his or her profit up to the amount of the contribution to the partnership. This is not necessarily the case absent a partnership. And worse yet, because the IRS audits a few years in arrears, it might audit just one of the partners and reallocate the expenses away from the party that incurred them. The statute of limitations would likely have run on the other partner, which happens, resulting in lost tax deductions for both parties.

Then there are possible complications from depreciation deductions. Depreciation generally follows the allocations, which, absent a partnership agreement, may follow distributions. The distributions in this case were not equal. Thus, the depreciation deductions would seem to be allocated unevenly between the partners. Absent a partnership for federal tax purposes, the depreciation may have been taken by one party. The IRS on audit might reverse that, resulting in the party who claimed depreciation owning more in tax. The same timing consideration noted above would likely be at issue. The result could be lost depreciation deduction for one or more parties.

There are other considerations too, such as the allocation of income and expense and capital accounts, whether the sale of property (such as the horses) results in capital or ordinary income, whether self-employment tax applies, whether 1031 exchanges are possible, etc. These can all be at issue depending on whether the entity is a partnership or not for federal tax purposes.

The Takeaway

This case illustrates the complex interplay between state partnership law and federal tax law. Even though the jury found a partnership existed under Texas law, the court held it was unenforceable due to the statute of frauds. This left the parties without a valid state law partnership. However, this does not preclude the IRS from determining that a partnership exists for tax purposes. This could lead to several different federal tax consequences, most of which could result in more tax being due than would otherwise be due if the parties had planned and documented their business venture upfront.

Watch Our Free On-Demand Webinar

In 40 minutes, we'll teach you how to survive an IRS audit.

We'll explain how the IRS conducts audits and how to manage and close the audit.