Partnership or Sch C

[Scarecrow]

OK, somebody said there are a couple of guys on this board that like to argue. How would you handle this?

Husband and wife own a business, joint. They also file a joint 1040. No other owners. They have not incorporated. Should they file a 1065 as a partnership, or can they do one Schedule C and split SE tax on two separate Schedule SEs?

Lets say they do NOT live in a community property state.

[Armando Beaujolais]

Here We Go Again

If a husband and wife carry on a business together, they are a partnership.

The excuses for not filing a partnership return when a partnership exists are usually related to the practitioner not wanting to go through the trouble of filing Form 1065.

Or some variation of "You can get away with it."

The bottom line is that a partnership return should be filed for a partnership.

[Bees Knees]

No 1065 required

I should also probably eat my carrots and peas before diving into that chocolate cake. That doesn’t mean the IRS can force me to do it.

A husband and wife can “get away with” not filing a partnership return because the code says they can:

IRC Section 6231(a)(1)(B)(i), “The term partnership shall not include any partnership having 10 or fewer partners each of whom is an individual….”

Last count, most husbands and wives in this country make up 2, which is no more than 10, which means a husband and wife partnership is not a partnership according to section 6231.

Rev. Proc. 84-35 says: “The penalty [for not filing Form 1065) will not be imposed if the partnership can show reasonable cause for failure to file a complete or timely return. Smaller partnerships (those with 10 or fewer partners) will not be subject to the penalty under this reasonable cause test so long as each partner fully reports his share of the income, deductions, and credits of the partnership ....”

Bottom line is, if income, deductions, and credits are properly reported on their joint 1040 and SE tax is properly paid for each spouses’ work, then no penalty will be assessed for a husband and wife who do not file Form 1065.

My not wanting to go through the hassle of filing a 1065 has nothing to do with it. My not wanting to charge the client tons of extra dough for senseless paperwork is more like it. A partnership is not a corporation. You don’t have to jump through the formality hoops a corporation has to. So why waste the client’s money?

[Armando Beaujolais]

A husband and wife can “get away with” not filing a partnership return because the code says they can:

IRC Section 6231(a)(1)(B)(i), “The term partnership shall not include any partnership having 10 or fewer partners each of whom is an individual….”

IRC 6231 addresses only whether a partnership is subject to consolidated audit procedures and whether audit items need to be addressed at the partnership or individual level.

IRC 6231 does not address filing requirements or the definition of a partnership for filing purposes.

If a taxpayer falls under the exemption in 6231, they can still be treated as a partner in a partnership. All that code section means is that the IRS goes after the individual's return instead of the partnership's.

How about a husband/wife partnership that puts a $50,000 piece of equipment into service during the year, but the business doesn't make money? Any other partnership would be unable to deduct the Section 179 expense because of the income limitation. If filing two Schedule C's is the same thing as filing one Form 1065, why can the partners write off the Section 179 expense against their W2 income?

Sure, filing two Schedule C's or one Schedule C and two Schedule SE's will usually acheive the same result. Usually.

Go ahead and file your husband/wife partnerships as if the partnership doesn't exist. Then pray they don't get divorced or estranged, because then those not-so-cooperative lawyers will drag you into the middle of it when they're trying to determine how to split up the tax liability and liability for debt.

[Bees Knees]

Partnership or Schedule C - What was your point?

[I] IRC 6231 addresses only whether a partnership is subject to consolidated audit procedures and whether audit items need to be addressed at the partnership or individual level.

I agree. But so what? That proves my point. If the IRS can only audit the individual partner’s 1040 and can’t audit at the 1065 level (because there are 10 or fewer partners), why bother with the 1065? Even if you have one, they can’t look at it. They can only see how the partner reported partnership items at the partner level.

[I]IRC 6231 does not address filing requirements or the definition of a partnership for filing purposes.

If a taxpayer falls under the exemption in 6231, they can still be treated as a partner in a partnership. All that code section means is that the IRS goes after the individual's return instead of the partnership's.

IRC Section 6231 does not address filing requirements, but Rev. Proc. 84-35 does, and it quotes IRC Section 6231 as the REASON why a partnership with 10 or fewer partners will NOT be assessed the failure to file penalty. So your filing requirement argument is moot. You can choose to file a 1065 for convenience purposes, but it is not required because there is no penalty for not filing a 1065.

[I]How about a husband/wife partnership that puts a $50,000 piece of equipment into service during the year, but the business doesn't make money? Any other partnership would be unable to deduct the Section 179 expense because of the income limitation. If filing two Schedule C's is the same thing as filing one Form 1065, why can the partners write off the Section 179 expense against their W2 income?

How about you as the tax preparer, who chooses to not file the 1065 to save your client a little money, follow the rules and don’t try to claim a Section 179 deduction against W-2 income?

I never said partnership rules did not need to be followed. I said you don’t need to file the 1065. Rev. Proc. 84-35 says there is no penalty for failure to file a 1065 as long as “all partners have fully reported their shares of the income, deductions, and credits of the partnership on their timely filed income tax returns.” That means follow the rules, and calculate the Section 179 deduction passed through to the partners as if a 1065 had been filed.

[I] Go ahead and file your husband/wife partnerships as if the partnership doesn't exist. Then pray they don't get divorced or estranged, because then those not-so-cooperative lawyers will drag you into the middle of it when they're trying to determine how to split up the tax liability and liability for debt.

I see no reason why filing a 1065 or not filing a 1065 would have anything to do with splitting up marital assets in a divorce. A partnership is not a corporation. It is not separate and distinct from its owners. Partners are not shielded from partnership liabilities. The actions of one partner can affect all of the other partners. So why would filing a 1065 provide any single partner with any advantage in a divorce proceeding?

[Armando Beaujolais]

I agree. But so what? That proves my point. If the IRS can only audit the individual partner’s 1040 and can’t audit at the 1065 level (because there are 10 or fewer partners), why bother with the 1065?

Your point is that a partnership return is not required for a partnership until the number of partners goes above 10. I don't believe that's true. Why all the herculean efforts to avoid filing Form 1065? It's not that complicated. The rules are complicated, but the forms aren't.

I think lots of people don't want to file Form 1065 because they don't know the rules, not because filing the form bothers them. And if they don't know the rules, so much for the theory that it's O.K. to file on Schedule C as long as you follow the rules.

You can choose to file a 1065 for convenience purposes, but it is not required because there is no penalty for not filing a 1065.

O.K. So next time I do a tax return with itemized deductions, I don't have to attach Schedule A because there's no penalty for not doing so, and therefore the form is not required. It's just a convenience. I'll just forget about Schedule C, Schedule D, Schedule SE, Form 2106. There's no penalty for not filing those forms either. Gosh, tax preparation just got a whole lot simpler!

Not really. If you took out the forms and schedules that don't have penalities for failure to file, you'd reduce the size of the tax code and regulations to a few hundred pages. But that's not realistic.

I must admit, the thought of filing Form 1065 being a "choice" and only filed for "convenience" is an interesting concept. What other forms and schedules are only filed if you choose and only filed for the sake of convenience?

That means follow the rules, and calculate the Section 179 deduction passed through to the partners as if a 1065 had been filed

O.K. Let me get this straight. You compute partnership income, expenses, allocate net profit or loss, account for guaranteed payments to partners, make special allocations, report passthrough items separately, and adhere to all the partnership rules and regulations, make all the required calculations, then refuse to use the prescribed forms for what reason?

Lots of partnerships with eight, nine, or ten partners would be dancing in the streets to find out that they're not required to file partnership returns, if it were true.

[Bees Knees]

Calm down.

Your point is that a partnership return is not required for a partnership until the number of partners goes above 10. I don't believe that's true.

“REV. PROC. 84-35

SECTION 1. PURPOSE.

The purpose of this revenue procedure is to update Rev. Proc. 81-11, 1981-1 C.B. 651, to conform to the small partnership provisions of section 6231(a)(1)(B) of the Internal Revenue Code. Rev. Proc. 81-11 sets forth the procedures under which partnerships with 10 or fewer partners will not be subject to the penalty imposed by section 6698 for failure to file a partnership return.”

Believe what you want, but Rev. Proc. 84-35 is pretty clear. A partnership return is not required until the number of partners goes above 10.

Why all the herculean efforts to avoid filing Form 1065? It's not that complicated. The rules are complicated, but the forms aren't.

If it is so simple, why do you charge extra to do a 1065? Putting it all on a Schedule C and splitting the SE tax is even simpler.

I think lots of people don't want to file Form 1065 because they don't know the rules, not because filing the form bothers them.

Not me. I know the rules. That’s why I know I don’t have to be bothered by filing a 1065.

O.K. So next time I do a tax return with itemized deductions, I don't have to attach Schedule A because there's no penalty for not doing so, and therefore the form is not required. It's just a convenience. I'll just forget about Schedule C, Schedule D, Schedule SE, Form 2106. There's no penalty for not filing those forms either. Gosh, tax preparation just got a whole lot simpler!

Yes there is a penalty for not filing a Schedule C, D, SE or Form 2106. Its called code section 6702; frivolous income tax returns. You can get hit with a $500 penalty if your return “does not contain information on which the substantial correctness of the self-assessment may be judged.” There is no Rev. Proc. that allows you to by-pass this rule. There is one, however, for by-passing the 1065 filing requirements.

I must admit, the thought of filing Form 1065 being a "choice" and only filed for "convenience" is an interesting concept. What other forms and schedules are only filed if you choose and only filed for the sake of convenience?

I don’t know. You tell me. The 1065 is the only one I know of that has a Rev. Proc. saying you have a choice.

If the Rev. Proc. doesn’t mean you have a choice, then what DOES it mean when it says “partnerships with 10 or fewer partners will not be subject to the penalty imposed by section 6698 for failure to file a partnership return.” ?

O.K. Let me get this straight. You compute partnership income, expenses, allocate net profit or loss, account for guaranteed payments to partners, make special allocations, report passthrough items separately, and adhere to all the partnership rules and regulations, make all the required calculations, then refuse to use the prescribed forms for what reason?

To save my client from shelling out the extra cost of filing a 1065. And to save the time it takes me to fill out the thing.

And 99% of my small business clients don’t make special allocations. One Schedule C with 2 Schedule SEs do just fine, in the majority of the cases. Yeah, I guess if I had to do the Mall of America’s LLC partnership return, I’d choose to file a 1065 for all of those “special” tax rules most of us never see in real life. Most mom and pop operations, however, don’t need one.

Lots of partnerships with eight, nine, or ten partners would be dancing in the streets to find out that they're not required to file partnership returns, if it were true.

I don’t know of lots of partnerships with eight, nine, or ten partners. I’ve never had a partnership with more than 4 people.

We weren’t talking about them, however. We were talking about a husband and wife, no other partners. They file a joint 1040. Why bother with a 1065 when they don’t have situations that require fancy partnership rules that only a 1065 can handle?

[Armando Beaujolais]

In Context Please

As long as we're looking at Revenue Procedure 84-35 as the supposed authoritative pronouncement that a husband/wife partnership does not need to file a partnership return, let's look at the relevant passages instead of cleverly cutting certain phrases out.

Sec. 2, .03:

Section 6231(a)(1)(B) of the Code provides an exception to the definition of "partnership" for small partnerships. In general, the term "partnership" does not include a partnership if the partnership has 10 or fewer partners, each of whom is a natural person (other than a nonresident alien) or an estate, and each partner's share of each partnership item is the same as such partner's share of every other item. A husband and wife, and their estates, are treated as one partner for this purpose.

Wait a minute. I thought the husband and wife were supposed to report all the items on Schedule C as if a partnership didn't exist, and then split out the income on two Schedule SE's. I thought you proved it by quoting Rev. Proc. 84-35. But that can't be. Rev. Proc. 84-35 says a husband and wife are one partner for purposes of the revenue procedure. But you can't have just one partner in a partnership. How are you going to split Schedule SE into two if you only have one partner?

The answer is, "You can't." Rev. Proc. 84-35 deals only with audit procedures, deals only with things that happen after the return is filed, not with filing requirements. That's why it breaks down when you try to apply the wrong fact patterns to it. If you're going by Rev. Proc. 84-35 as the final authority with regard to partnership reporting, remember that the procedure states that it is impossible for a husband/wife partnership to exist in the first place because they're considered one partner. Of course that's not true.

As stated in the IRS 1040 Instructions for Schedule C:

"If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Scheudle C or C-EZ. Instead, file Form 1065. See Pub. 541 for more details."

Some people want to add

"...unless you think Form 1065 is too much trouble or too expensive for your client. In that case just go ahead and file Schedule C and split out the self-employment income between spouses on two Schedules SE...."

but it's not in there no matter how hard you look.

[Bees Knees]

Schedule C Instruction? Or Suggestion?

Wait a minute. I thought the husband and wife were supposed to report all the items on Schedule C as if a partnership didn't exist, and then split out the income on two Schedule SE's. I thought you proved it by quoting Rev. Proc. 84-35. But that can't be. Rev. Proc. 84-35 says a husband and wife are one partner for purposes of the revenue procedure. But you can't have just one partner in a partnership. How are you going to split Schedule SE into two if you only have one partner?

The husband and wife counting as one partner ONLY applies in the context of adding all partners up and coming in with 10 or less. So if you have a husband and wife plus 9 other guys as partners, those 11 partners only count as 10, for purposes of Rev. Proc. 84-35. So you could have 10 couples who make up 20 total people and still fall under Rev. Proc. 84-35 because each of those couples count as only one partner.

It has nothing to do with how income is passed through to each individual partners’ 1040.

Your argument reminds me a lot of those clients who call and say how they worked for some guy and he was supposed to issue a 1099, but he hasn’t issued one yet, so now what? The client seems to think we can’t file the 1040 without first getting a 1099.

Of course you can file the 1040 without the 1099…did you kept track of the income? The client says yes. You say, well, the 1099 is not attached to the 1040, so we can go ahead and file your 1040 without that 1099…as long as you are sure you know how much income was supposed to be reported on that 1099.

Substitute the K-1 for the 1099. What’s the difference?

And if you would prefer to have each partner properly report their share of partnership items on the Schedule E instead of Schedule C, fine. But as long as you report the correct income, you don’t need to first have the K-1 from the 1065 in your hand, anymore than you need a 1099-MISC before filling out a Schedule C.

As stated in the IRS 1040 Instructions for Schedule C:

"If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Scheudle C or C-EZ. Instead, file Form 1065. See Pub. 541 for more details."

Some people want to add

"...unless you think Form 1065 is too much trouble or too expensive for your client. In that case just go ahead and file Schedule C and split out the self-employment income between spouses on two Schedules SE...."

but it's not in there no matter how hard you look.

You are correct, its not there.

So lets look at reality. I have a husband and wife client, who “jointly own and operate a business and share in the profits.” That’s all they do, run their joint business together as partners. No W-2 income. Lets say they net about $80,000 per year. Each contributes about half the work, so I put all income and expenses on a Schedule C, and split the $80,000 into two Schedule SEs, one for each. I don’t get fancy with special allocations, and I don’t abuse Section 179.

Now my client gets audited. The IRS auditor looks at the bank statements, looks at the receipts, does a life style analysis and discovers that their standard of living is in line with the $80,000 they reported as income on their 1040. Everything looks great.

Then the auditor pulls out a Schedule C instruction booklet, looks at me and says, “you know, you really should have first filed a 1065, issue a K-1, report the K-1 items on a Schedule E, and then have that Schedule E go to the Schedule SE.”

I say: “Yeah, I know what the instructions say, but that was too much bother for me. It was easier for me to just throw it all on the Schedule C.”

The auditor says: “Yeah, you got the end results correct, but you see these Schedule C instructions told you not to do it that way.”

I say: “Yeah, I know the Schedule C instructions said not to do it that way, but what are those instructions going to do to me if I don’t obey? Are they going to give my computer a virus or something?”

The auditor says: “Well, the only thing I can do to force you to obey the Schedule C instructions is to issue your clients a $50 per month per partner penalty under section 6698 for failure to file a 1065.”

I say: “Go ahead. But I will then insist that you abate the penalty under the reasonable cause exception per Rev. Proc. 84-35 because this partnership has 10 or fewer partners, and the partnership never elected under section 6231(a)(1)(B)(ii) to be covered under the consolidated audit procedures.”

The auditor says: “Hmmmm, never heard of that, I will have to ask my supervisor. I’ll get back to you.”

Three weeks later, I get a no change letter from the IRS with no mention of a penalty for failure to file the 1065.

By the way, I have actually used Rev. Proc. 84-35 in real life with clients and have never been assessed a late filing penalty for not filing the 1065.

And so what does that say about your precious Schedule C suggestions….er…I mean instructions?

[Scarecrow]

Group 1 or Group 2?

Big Picture

This is a typical example of why there are 1 million words in the Internal Revenue Code and 6 million words in the Regulations. Every time Congress comes up with new tax laws, some people try to poke holes in them to find ways to get around the rules. So Congress comes up with more rules to close the loopholes, causing more poking, causing more rules and regulations, and so on.

There are two kinds of people in this world.

Group 1: There are those of us who follow the rules. We want to fit in with the crowd. If there are two windows open at the post office, but only one has a line of people at it, we get in line, not wanting to be different. We want to be told how to fill out a form. We want things to be in black and white. There are no ifs in mathematics. 2 + 2 always equals 4.

Group 2: Then there are those who have to question every rule ever invented from the beginning of time. Why can’t I eat that fruit? Why do I have to do it your way? Why can’t 2 + 2 sometimes equal 5? Why can’t I file a Schedule C instead of a 1065?

Group 2 people drive group 1 nuts.

Except for traffic rules. The freeway here going through Minnetonka has a 60 mile per hour speed limit sign posted. But everyone knows that the highway patrol won’t stop you unless you go 65 or over. So that causes everyone to think that 60 mile per hour speed limit signs really say 65, and 70 mile per hour signs really say 75. And so on. If you try to go 60, you get tons of people on your tail trying to force you off the road. I think once you get behind the wheel of a car, you change from being a Group 1er to a Group 2er.

It is usually those in group 1 who pass rules to try and control those in group 2. Until someone from group 2 comes up with a new invention that makes life simpler for those in group 1, like when they invented those little plastic things you stick in the middle of the pizza box so your pizza don’t get crushed during delivery.

I don’t know. I probably will continue to just file the 1065 because that’s what the instructions tell me to do. I suppose if Bees and his group 2 cronies irritate the IRS into re-writing their instructions, then I’ll try the Schedule C approach.

caw

[Pepper]

I love this back and forth from you two!!!

This is wonderful. I'm afraid to say I see both sides!

[Unregistered]

Bees

The procedure is good for getting out of a penalty situation and may be some comfort for husband, wife, family or only your clients involved. If your client the wife is in partnership with five others, none your clients, are you still going to say it is under 10 so she can give a copy of her schedule C to the other 5 and avoid the cost of a 1065. The revenue procedure is only good if "all" items are included on a timely filed returns by the individual "partners". If not the penalties will be assessed.

My situation, husband and wife, have two Schedule C's-tough client to get information and get done. Ultra Tax has allowed you to use JOINT as a filing status of the Schedule C and we always have. Three years ago we get a letter from the IRS saying stop that there is no such thing as a joint schedule C, did the SEs OK. I sent them a letter saying I believed the information was not incorrect as filed and we would continue to do the same. We never heard anything back and have continued with the Cs. This is a return where the amounts are not significant and they both should be retired soon...

I would never do that for partners not family or not clients.

[Black Bart]

Armando/Bees-1065?

Glad y'all got that ferocious zeal out of your systems. And to think, that guy thought that [I] opened a can of worms the other day with that post about SE health deductions. It appears that all extant partnership regs, possible treatments, and opinions dating from the dawn of time until the twelfth of never have now been examined, analyzed, discussed, and
discarded. You both make eloquent cases and we have all received enlightenment of EA quality. What about calling it a draw?

Since the two of you are in this venture together; I hope it's a corporation 'cause if it's not, it's going to be extremely interesting next April as to what you file. You might consider flipping a coin.

[Bees Knees]

Draw? Hardly.

Armando and I get some of our best ideas when we argue like this on the board. We were thinking about arguing about the SE tax on LLC members next. I, as usual, will expound on the correct conclusion while Armando takes the losing side of the argument. Next, week, same time, same station...ONLY on TheTaxBook message board....

[S T]

Husband and Wife Schedule C or Form 1065

Well being in a community property state and after reviewing at least the SE Rules, I see no way around filing the form 1065 if the husband and wife are truly partners. The instructions are fairly clear in that the husband and wife need to file a form 1065, then they each receive their credits for SE. One important factor!

We had this come up in a divorce issue in Calif. Fortunately for me the divorce attorney is also a tax attorney. The wife who is filing for divorce was "whining" and trying to claim in the divorce settlement that she had not received any credits on her SSA Account and trying to claim as part of the divorce settlement. It was finally put to rest and not an issue for the divorce settlement.

The taxpayers jointly own a business but chose to file as a schedule C under the husband's account. Thereby only the husband receives the credit for SS/medicare, no child care, etc. The wife (that is now whining) did not even want to have a W-2 issued to her. They didn't want to pay the payroll tax associated with it. Which is really the same as paying the SE tax on the return.

So now I am of the mind that if it is a community property state, and it is a husband and wife business, that either (1) it becomes a partnership and form 1065 is filed so each report to their own SSA account or in the alternative, the spouse receive wages and report on W-2. Or S Corp!

In this day and age you just never know what will happen with marital bliss and business!

Sandy