Exclusion From Partnership Rules

Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income. However, the partners are not exempt from the rule that limits a partner's distributive share of partnership loss to the adjusted basis of the partner's partnership interest. Nor are they exempt from the requirement of a business purpose for adopting a tax year for the partnership that differs from its required tax year, discussed under Tax Year, later.

Investing partnership.   An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of investment property meet all the following requirements.

• They own the property as co-owners.
• They reserve the right separately to take or dispose of their shares of any property acquired or retained.
• They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year.

Operating agreement partnership.   An operating agreement partnership group can be excluded if the participants in the joint production, extraction, or use of property meet all the following requirements.

• They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights.
• They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used.
• They do not jointly sell services or the property produced or extracted. Each separate participant can delegate authority to sell his or her share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year.

However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing, or processing for persons who are not members of the organization.

Electing the exclusion.   An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing the partnership return for the first tax year for which exclusion is desired. This filing date includes any extension of time. See section 1.761-2(b) of the regulations for the procedures to follow.

Tax Year

Taxable income is figured on the basis of a tax year. A tax year is the accounting period used for keeping records and reporting income and expenses.

Partnership.   A partnership determines its tax year as if it were a taxpayer. However, there are limits on the year it can choose. In general, a partnership must use its required tax year. A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. For a partnership, the required tax year is the tax year determined under section 706 of the Internal Revenue Code and section 1.706 of the regulations. See Required Tax Year, later. Exceptions to this rule are discussed under Exceptions to Required Tax Year, later.

Partners.   Partners can change their tax year only if they receive permission from the IRS. This also applies to corporate partners, who are usually allowed to change their accounting periods without prior approval if they meet certain conditions.

Closing of tax year.   Generally, the partnership's tax year is not closed because of the sale, exchange, or liquidation of a partner's interest, the death of a partner, or the entry of a new partner. However, if a partner sells, exchanges, or liquidates his or her entire interest, or a partner dies, the partnership's tax year is closed for that partner. See Distributive share in year of disposition under Partner's Income or Loss, later.

Required Tax Year

A partnership generally must conform its tax year to its partners' tax years. The rules for determining the required tax year are as follows.

• Majority interest tax year. If one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest), the partnership must use the tax year of those partners.

  Testing day. The partnership determines if there is a majority interest tax year on the testing day, which is usually the first day of the partnership's current tax year.

  Change in tax year. If a partnership's majority interest tax year changes, it will not be required to change to another tax year for 2 years following the year of change.

• Principal partner. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
• Least aggregate deferral of income. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

Least aggregate deferral of income.   The tax year that results in the least aggregate deferral of income is determined as follows.

1. Figure the number of months of deferral for each partner using one partner's tax year. Count the months from the end of that tax year forward to the end of each other partner's tax year.
2. Multiply each partner's months of deferral figured in step (1) by that partner's interest in the partnership profits for the year used in step (1).
3. Add the results in step (2) to get the total deferral for the tax year used in step (1).
4. Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

The partner's tax year that results in the lowest total number in step (3) is the tax year that must be used by the partnership. If the calculation results in more than one year qualifying as the tax year that has the least aggregate deferral, the partnership can choose any one of those tax years as its tax year. However, if one of the years that qualifies is the partnership's existing tax year, the partnership must retain that tax year.

Example.   Rose and Irene each have a 50% interest in a partnership that uses a fiscal year ending June 30. Rose uses a calendar year while Irene has a fiscal year ending November 30. The partnership must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners. This was determined as shown in the following table.

Year End 12/31:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	-0-	-0-
Irene	11/30	0.5	11	5.5
Total Deferral				5.5
Year End 11/30:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	1	0.5
Irene	11/30	0.5	-0-	-0-
Total Deferral				0.5

Special de minimis rule.   If the tax year that results in the least aggregate deferral produces an aggregate deferral that is less than 0.5 when compared to the aggregate deferral of the current tax year, the partnership's current tax year is treated as the tax year with the least aggregate deferral.

When determination is made.   Generally, determination of the partnership's required tax year under the least aggregate deferral rules is made at the beginning of the partnership's current tax year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership.

Procedures.   A partnership can get an automatic approval to change to a required tax year by filing Form 1128 with the Service Center where it files its federal income tax returns. The partnership should write FILED UNDER REV. PROC. 2002-38 at the top of page 1 of Form 1128 and file it by the due date (including extensions) for filing the short period tax return.

Short period return.   When a partnership changes its tax year, a short period return must be filed. The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year.

If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with the short period return showing the computations used to determine that tax year. The Form 1128 should also be attached to the partnership tax return. The short period return must indicate at the top of page 1, FILED UNDER SECTION 1.706-1.

Exceptions to Required Tax Year

There are certain exceptions to the required tax year rule.

Business purpose tax year.   If a partnership establishes an acceptable business purpose for having a tax year different from its required tax year, the different tax year can be used. Administrative and convenience business reasons such as the deferral of income to the partners are not sufficient to establish a business purpose for a particular tax year.

See Business Purpose Tax Year in Publication 538 for more information.

Section 444 election.   A partnership can elect under section 444 of the Internal Revenue Code to use a tax year different from its required tax year. Certain restrictions apply to this election. In addition, the electing partnership may be required to make a payment representing the value of the extra tax deferral to the partners.

See Section 444 Election in Publication 538 for more information.

52-53-week tax year.   A partnership can use a tax year other than its required tax year if it elects a 52-53-week tax year that ends with reference to its required tax year or a tax year elected under section 444 (discussed earlier). See 52-53-Week Tax Year under Fiscal Year in Publication 538 for information on the 52-53-week tax year.

Partnership Return (Form 1065)

Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return.

A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.

See the instructions for Form 1065 for more information about who must file Form 1065.

Due date.   Form 1065 generally must be filed by April 15 following the close of the partnership's tax year if its accounting period is the calendar year. A fiscal year partnership generally must file its return by the 15th day of the 4th month following the close of its fiscal year.

If a partnership needs more time to file its return, it should file Form 8736 by the regular due date of its Form 1065. The automatic extension is 3 months.

If the partnership has made a section 444 election to use a tax year other than a required year, an automatic extension of time for filing a return will run concurrently with any extension of time allowed by the section 444 election. The filing of an application for extension does not extend the time for filing a partner's personal income tax return or for paying any tax due on a partner's personal income tax return.

If the due date for filing a return falls on a Saturday, Sunday, or legal holiday, the due date is extended to the next business day.

Schedule K-1 due to partners.   The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.

Penalties

To help ensure that returns are filed correctly and on time, the law provides penalties for failure to do so.

Failure to file.   A penalty is assessed against any partnership that must file a partnership return and fails to file on time, including extensions, or fails to file a return with all the information required. The penalty is $50 times the total number of partners in the partnership during any part of the tax year for each month (or part of a month) the return is late or incomplete, up to 5 months.

The penalty will not be imposed if the partnership can show reasonable cause for its failure to file a complete or timely return. Certain small partnerships (with 10 or fewer partners) meet this reasonable cause test if:

1. All partners are individuals (other than nonresident aliens), estates, or C corporations,
2. All partners have timely filed income tax returns fully reporting their shares of the partnership's income, deductions, and credits, and
3. The partnership has not elected to be subject to the rules for consolidated audit proceedings (explained later under Partner's Income or Loss, in the discussion under Reporting Distributive Share).

The failure to file penalty is assessed against the partnership. However, each partner is individually liable for the penalty to the extent the partner is liable for partnership debts in general.

If the partnership wants to contest the penalty, it must pay the penalty and sue for refund in a U.S. District Court or the U.S. Court of Federal Claims.

Failure to furnish copies to the partners.   The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners. A penalty for each statement not furnished will be assessed against the partnership unless the failure to do so is due to reasonable cause and not willful neglect.

Trust fund recovery penalty.   A person responsible for withholding, accounting for, or depositing or paying withholding taxes who willfully fails to do so can be held liable for a penalty equal to the tax not paid.

Willfully in this case means voluntarily, consciously, and intentionally. Paying other expenses of the business instead of the taxes due is considered willful behavior.

A responsible person can be a partner, an employee of the partnership, or an accountant. This may also include someone who signs checks for the partnership or otherwise has authority to cause the spending of partnership funds.

Other penalties.   Criminal penalties can be imposed for willful failure to file, tax evasion, or making a false statement.

Other penalties can be imposed for the following actions.

• Not supplying a taxpayer identification number.
• Not furnishing information returns.
• Underpaying tax due to a valuation misstatement.
• Not furnishing information on tax shelters.
• Promoting abusive tax shelters.

However, certain penalties may not be imposed if there is reasonable cause for noncompliance.

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