A HISTORY AND ANALYSIS OF THE CO-OWNERSHIP...

A HISTORY AND ANALYSIS OF THE CO-OWNERSHIP-PARTNERSHIPQUESTIONBy Bradley T. Borden, Sandra Favelukes, and Todd E. Molz

Table of Contents

I. The Co-Ownership-Partnership Question . 1175II. The Early History . . . . . . . . . . . . . . . . . . 1176

A. Partnerships Originally Disregarded . . . 1176B. Early Partnership Reporting

Requirements . . . . . . . . . . . . . . . . . . . 1176C. Early Co-Ownership Rulings . . . . . . . . 1176D. A Broad Statutory Definition of Tax

Partnership . . . . . . . . . . . . . . . . . . . . 1177E. Early Co-Ownership-Joint Production

Rulings . . . . . . . . . . . . . . . . . . . . . . . 1178F. Family Partnerships . . . . . . . . . . . . . . . 1180G. Early Judicial Considerations . . . . . . . . 1181

III. The 1954 Code . . . . . . . . . . . . . . . . . . . . 1182A. Qualifying for the Section 761 Election . 1182B. Effect of the Section 761 Election . . . . . . 1183

IV. Classifying UnincorporatedArrangements . . . . . . . . . . . . . . . . . . . . . 1184A. The Original Section 761 Regulations . . 1184B. A Potpourri of Cases and Rulings . . . . . 1185C. Current Section 7701 Regulations . . . . . 1187D. Section 761(a)(1) Election . . . . . . . . . . . 1188

VI. The Co-Ownership-Partnership Test . . . . 1188

I. The Co-Ownership-Partnership Question

The recent promotion of syndicated tenancy-in-common (TIC) interests as section 10311 replacement realestate has focused new attention on whether co-ownership of property creates a partnership for federaltax purposes (the co-ownership-partnership question).Within the past few years, the IRS has published guid-ance regarding that question2 and recently requestedcomments regarding the application of the election undersection 761(a)(1) to co-ownership arrangements.3

Although TIC promoters and section 1031 investorshave a significant interest in the co-ownership-partnership question, the stakes in answering the ques-tion extend beyond the TIC industry. They include: (1)the proper tax year for recognizing gain or loss,4 (2) thecharacter of gain or loss,5 (3) the level at which an election

1Unless specified otherwise, section references are to theInternal Revenue Code of 1986, as amended (the code).

2Rev. Proc. 2002-22, 2002-1 C.B. 733, Doc 2002-6847, 2002 TNT54-12, and Rev. Rul. 2004-86, 2004-33 IRB 191, Doc 2004-14855,2004 TNT 140-13.

3Notice 2004-53, 2004-33 IRB 89, Doc 2004-14863, 2004 TNT140-11 (seeking comments on three issues: (1) the application ofthe conditions set forth in Treas. reg. section 1.761-2(a)(2) andwhether those conditions should be revised, modified, or clari-fied; (2) the facts that should be considered in determiningwhether participants in the joint purchase, retention, sale, orexchange of investment property have reserved the right sepa-rately to take or dispose of their underlying shares in theproperty; and (3) the meaning of investment property forpurposes of Treas. reg. section 1.761-2(a)(2)).

4See, e.g., Joe Balestrieri & Co. v. Commissioner, 177 F.2d 867 (9thCir. 1949); Bentex Oil Corporation v. Commissioner, 20 T.C. 565(1953); Estate of Levine v. Commissioner, 72 T.C. 780 (1979).

5See, e.g., Estate of Appleby v. Commissioner, 41 B.T.A. 18 (1940);Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953); Coffin v. U.S.,120 F. Supp. 9 (S.D. Alabama 1954); Luckey v. Commissioner, 334F.2d 719 (9th Cir. 1964); Luna v. Commissioner, 42 T.C. 1067 (1964);Podell v. Commissioner, 55 T.C. 429 (1970); S&M Plumbing Co. v.

Bradley T. Borden is an associate professor atWashburn University School of Law in Topeka, Kan-sas. Sandra Favelukes is an associate with the Bostonlaw firm of Foley Hoag, LLP. Todd E. Molz is a partnerin the Los Angeles office of Munger Tolles & Olson.

The authors believe that the use of interests insyndicated tenancy-in-common arrangements as re-placement property for section 1031 exchanges at-taches new significance to the question of when aco-ownership arrangement should be treated as apartnership for federal tax purposes (the co-ownership-partnership question). This article exam-ines the history of partnership taxation and the au-thority that addresses the coownership-partnershipquestion. This examination reveals that there is con-siderable confusion in this area, including an ambigu-ous overlap between the ‘‘check-the-box’’ rules andthe rules governing when a partnership can elect outof subchapter K. Because the authors find this confu-sion to exist, they recommend that the IRS provideguidance that will more clearly define the term ‘‘sepa-rate entity’’ in the section 7701 regulations.

This article was originally presented by the authorsat the January 2005 American Bar Association Sectionof Taxation midyear meeting at the partnerships andLLCs committee meeting in San Diego, Calif., as‘‘Co-Ownership or Partnership? Drawing the Line.’’

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can be made,6 (4) the amount of limits that should beapplied,7 (5) the nature of property transferred,8 (6)whether the rules of subchapter K apply,9 (7) the personto whom income or loss should be allocated,10 (8) theproper method of accounting,11 (9) the application ofTEFRA audit rules for partnerships,12 and (10) whethercertain costs can be deducted or must be capitalized.13

Given the broad implications, any consideration of theco-ownership-partnership question should extend be-yond the immediate needs of the TIC industry.

To help frame the issues relating to the co-ownership-partnership question, this article reviews the history ofthe question, identifies the tests used by courts and theIRS when addressing the question, reviews recent devel-opments, and suggests that any future guidance shouldaddress the question comprehensively and provide de-finitive guidance.

II. The Early HistoryThe co-ownership-partnership question emerged from

early income tax laws14 that imposed a tax on corpora-tions and individuals, but disregarded partnerships. Be-cause of the separate tax on corporations, the questionthat received the most attention initially was whether anorganization was a corporation or a partnership forfederal tax purposes.15 Congress nonetheless realizedthat it needed to enact rules to govern the tax accountingand reporting of partnership income. The enactment ofpartnership tax accounting and tax reporting rules initi-ated the co-ownership-partnership question because par-ties had to distinguish between arrangements that weresubject to accounting and reporting and those that werenot. After enacting accounting and reporting rules, Con-gress had to enact a definition of partnership to subject allorganizations that were similar to partnerships to auniform system of reporting and accounting.

A. Partnerships Originally Disregarded

The earliest income tax laws disregarded partnershipscompletely.16 Congress acknowledged partnerships inearly income tax acts merely to distinguish them fromcorporations, which were subject to income tax.17 The1913 act provided that ‘‘any person carrying on businessin partnership shall be liable for income tax only in theirindividual capacity, and the share of the profits of thepartnership to which any taxable partner would beentitled if the same were divided, whether divided orotherwise, shall be returned for taxation, and the taxpaid, under the provisions of this section.’’18 That act alsorequired partnerships to report profits and identify indi-vidual partners, when requested by the IRS.19 Thus, ourearliest income tax laws disregarded partnerships anddid not impose partnership reporting requirements, butthey granted the IRS the authority to require partnershipsto report requested information.

B. Early Partnership Reporting Requirements

Congress later realized that uniform rules governingpartnership tax accounting and reporting were needed toconsistently tax owners of different partnerships. In theRevenue Act of 1917, Congress allowed partnerships tocompute income based on their own fiscal years andestablished rules for applying tax rates to the income ofpartnerships that straddled tax years with different taxrates.20 That appears to be the first time Congress recog-nized partnerships as separate from their partners for taxpurposes. Thus, the current partnership tax rules appearto have been born of a need to consistently tax individu-als who invested in partnerships.

The reporting requirements became more complexwhen, in 1918, Congress required partnerships to com-pute net income in the same manner and on the samebasis as an individual21 and required partners to includetheir ‘‘distributive share[s] of the net income of thepartnership’’ in their respective individual incomes forthe individual tax years during which the partnership’stax year ended.22 Up to that point, however, there was nostatutory definition of partnership. The early laws simplydealt with accounting and reporting issues.

C. Early Co-Ownership Rulings

Before the enactment of the first statutory definition oftax partnership, the IRS considered the co-ownership-partnership question in rulings and regulations. Thoseearly IRS pronouncements demonstrate that there has

Commissioner, 55 T.C. 702 (1971); Ian T. Allison, T.C. Memo.1976-248, 35 T.C.M. (CCH) 1069 (1976); Underwriters Ins. Agencyof America, T.C. Memo. 1980-92, 40 T.C.M. (CCH) 5 (1980).

6See, e.g., I.T. 3713, 1945 C.B. 178; Rev. Rul. 54-42, 1954-1 C.B.64; Rev. Rul. 68-344, 1968-1 C.B. 569; Rev. Rul. 83-129, 1983-2 C.B.105; Rev. Rul. 56-500, 1956-2 C.B. 464; McShain v. Commissioner,68 T.C. 154 (1977); LTR 7919065 (Feb. 12, 1975).

7See, e.g., Rev. Rul. 65-118, 1965-1 C.B. 30; Bussing v. Commis-sioner, 88 T.C. 449 (1987).

8See, e.g., McShain v. Commissioner, 68 T.C. 154 (1977); Rev.Rul. 75-374, 1975-2 C.B. 261.

9See, e.g., Olin Bryant v. Commissioner, 46 T.C. 848 (1966); LTR8315003 (June 17, 1982).

10See, e.g., Commissioner v. Tower, 327 U.S. 280 (1946); Lusthausv. Commissioner, 327 U.S. 293 (1946); Commissioner v. Culbertson,337 U.S. 733 (1949); Hahn v. Commissioner, 22 T.C. 212 (1954).

11See, e.g., Bartholomew v. Commissioner, 186 F.2d 315 (8th Cir.1951).

12See, e.g., William G. Alhouse, T.C. Memo. 1991-652, 62 T.C.M.(CCH) 1678 (1991).

13See, e.g., Madison Gas & Electric v. Commissioner, 633 F.2d 512(7th Cir. 1980).

14The term ‘‘income tax laws’’ is used to refer to thoseenacted after the ratification of the 16th Amendment.

15That question has been resolved with the promulgation ofthe check-the-box regulations discussed below.

16Tariff Act of 1913, section II A. Subdivisions 1 & 2, ch. 16, 38Stat. 166.

17Tariff Act of 1913, section II G.(a), ch. 16, 38 Stat. 172.18Tariff Act of 1913, section II D, ch. 16, 38 Stat. 169. The 1916

act was a little more specific, providing that partnership incomeitems that are excluded from gross income (interest fromtax-exempt bonds) are not reported as income by the partner-ship. Revenue Act of 1916, section 8(e), ch. 463, 39 Stat. 762-3.

19Tariff Act of 1913, section II D, ch. 16, 38 Stat. 169.20Revenue Act of 1917, section 1204(e), ch. 63, 40 Stat. 332.21Revenue Act of 1918, section 218(d), ch. 18, 40 Stat. 1070.22Revenue Act of 1918, section 218(a).

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been a distinction between co-ownerships and partner-ships for tax purposes since the early days of our incometax laws.

1. Farmland. In 1923 the IRS ruled that two individualswho owned farmland as tenants in common, developedand farmed the property, and divided the net proceedsfrom the sale of the crops thereof were not partners.23

Without giving specific citations to prior tax decisions(indicating this may be the first ruling to consider theco-ownership-partnership question for tax purposes), theIRS stated that a mere tenancy in common does not createa partnership.24 More particularly, it allowed that ‘‘con-tributing a pro rata share of the investment or cost ofoperation [and] sharing the product [does not], withoutmore, create a partnership for income tax purposes.’’ TheIRS appeared to rely on substantive law,25 stating that the‘‘absence of mutual dependence or agency between theco-owners and [the ability of] any one of the co-owners[to] sell his interest without securing the consent of otherpart owners, which is contrary to one of the fundamentalattributes of a partnership[,]’’ demonstrates a partnershipdid not exist. The IRS did acknowledge, however, that ‘‘itis true that tenants in common may by agreement or bytheir conduct in dealing with their common propertybecome partners even inter sese[,]’’ acknowledging thatco-owners may preserve unto themselves the ability toelect to treat their co-ownership arrangement as a part-nership for federal tax purposes. In those cases, however,‘‘the evidence produced to establish the partnershiprelation must be clear and conclusive. And primarily thetest in such a case is whether the tenants in commonactually intended to assume a partnership relationship,such intention to be ascertained either by an agreementbetween them or by their conduct toward each other andthird parties.’’ Thus, very early on, the IRS recognized

that co-ownership did not create a partnership. The IRSdid, however, appear to recognize that co-owners whowere not in partnership could ‘‘elect’’ to be treated assuch by their conduct toward each other and thirdparties, and those actions would indeed create a partner-ship for tax purposes.2. Commercial retail store. In 1924 the IRS ruled that nopartnership existed, even though a business was con-ducted by co-owners.26 In that situation, an individualdied, leaving his estate, which included property and aretail merchandise store, to his wife and six children.They owned the inherited property and business astenants in common. One of the heirs of the estatemanaged the store. The IRS ruled, with little analysis,that the arrangement was a tenancy-in-common arrange-ment, not a partnership.3. Early regulatory definition of co-ownership. The IRSalso established a regulatory definition of co-ownership,stating that ‘‘[j]oint investment in and ownership of realand personal property not used in the operation of anytrade or business and not covered by any partnershipagreement does not constitute a partnership. Co-ownersof oil lands engaged in developing the property througha common agent are not necessarily partners.’’27 Thatprovision demonstrates that the IRS distinguished be-tween co-ownership and partnership early on and re-served a special place for oil and gas arrangements.Interestingly, the provision was not included in theregulations following the enactment of the federal statu-tory definition of tax partnership.28

D. A Broad Statutory Definition of Tax PartnershipIn 1932 Congress required partnerships to file returns

sworn to by any of the partners29 and, for the first timedefined ‘‘partnership’’ for federal tax purposes as ‘‘anysyndicate, group, pool, joint venture, or other unincorpo-rated organization, through or by means of which anybusiness, financial operation, or venture is carried on,and which is not, within the meaning of this Act, a trust,or estate or a corporation.’’30 That definition has largelysurvived until today.31 The legislative history indicatesthat before the provision was enacted, taxpayers did notmake partnership returns for the ‘‘income from opera-tions of joint ventures, syndicates, pools, and similarorganizations.’’32 Some taxpayers would not account forthe income of those ventures on an annual basis, butwould wait and report the income from the entire opera-tion when it was wound up.33 Congress was also con-cerned that members of those organizations would haveto account for the operations of those organizations onthe basis of their own accounting periods and according

23I.T. 1604, II-1 C.B. 1 (1923) (two parties owned farmland astenants in common; they furnished funds for supplies andmachinery equally, one of the co-owners was in active charge ofthe farming operations; the parties never entered into a partner-ship agreement; the parties claimed they never had an intent toenter into a partnership agreement (one co-owner said he wouldnot have tolerated such an arrangement and that the twoco-owners never considered themselves other than tenants incommon); and there was no evidence that a separate accountwas maintained for the arrangement).

24The IRS stated: ‘‘It seems courts are unanimous in uphold-ing this proposition of law and the Bureau has unqualifiedlyfollowed it in several instances. The cases in which the rule hasbeen applied by the Bureau have been mostly those involvingthe co-ownership of oil leaseholds and vessels operated by anagent in the business of importing and exporting.’’ Based oncases it cited, Donnell v. Harshe, 67 Mo. 170, Doak v. Swarm, 8 Me.170, Moody v. Rathburn, 7 Minn. 89, Dunham v. Loverock, 158 Pa.St. 197, and Millet v. Holt, 60 Me. 169, it appears the IRS wasreferring to substantive law, and applied substantive law in itsruling.

25The term ‘‘substantive law’’ is used throughout this articleto refer to state and common law. The terms ‘‘state law’’ and‘‘local law’’ are not used because decisions have relied on abroader body of common law, including at least one House ofLords decision, to decide whether arrangements are tax part-nerships.

26I.T. 2082, III-2 C.B. 176 (1924).27Regulations 74, Art. 1317 (December 1, 1931).28Regulations 77.29Revenue Act of 1932, section 189, ch. 209, 46 Stat. 223 (the

returns had to include the income and profits of the partnershipand information about the partners).

30Revenue Act of 1932, section 1111(a)(3), ch. 209, 47 Stat. 289.31See sections 7701(a)(2) and 761(a).3272d Cong. 1st Sess., H. Rept. 708, 53.33Id.



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to their own accounting methods, regardless of theaccounting period or method of accounting on which thesyndicate kept its books or records.34 Congress believedthat by defining the term ‘‘partnership’’ broadly, it couldeliminate that uncertainty and subject all similar arrange-ments to the partnership reporting requirements.35

The legislative history of the 1932 act establishes thatCongress enacted the definition for three primary pur-poses: (1) to require arrangements that are similar topartnerships to make a return, (2) to require arrange-ments that are similar to partnerships to account for theiroperations on an annual basis, and (3) apply a uniformaccounting period and accounting method to arrange-ments that are similar to partnerships. Although it ap-pears Congress was referring to the substantive lawdefinitions of joint venture, pool, syndicate, and group, inenacting the definition of partnership, its purpose was tosubject similar multimember economic arrangements touniform accounting and reporting requirements.

E. Early Co-Ownership-Joint Production RulingsEarly rulings on oil and gas co-ownership-joint pro-

duction arrangements are an important part of the his-tory of the co-ownership-partnership question. In 1934the IRS considered whether co-ownership and operationof certain oil and gas leases and the development of theproperty covered by the leases was a partnership.36 Thearrangement between the co-owners provided that (1)the gross revenue from such properties would be paid toand accounted for by the co-owners monthly, (2) theco-owners would pay expenditures in the developmentand operation of the properties monthly, (3) gross and netincome would be settled monthly, and (4) the accountingmethod would result in a complete periodical account forrevenue and expenses in the same manner as in the caseof a separate piece of property. The IRS ruled that theco-ownership and operation was a joint venture and thatwhile ‘‘ordinarily joint or co-ownership of property doesnot of itself constitute a partnership . . . [,] when theco-owners or joint owners agree to employ such propertyin the carrying on of a trade or business they becomepartners.’’37 The IRS ruled the arrangement thus consti-tuted a partnership within the definition in the 1932 act.The IRS also ruled, however, that the information re-quired to be reported by the arrangement (later referredto as a ‘‘qualified partnership’’38) could be different fromthat reported by other partnerships.39 The IRS’s analysis

indicates that it looked to substantive law to determinewhether the arrangement was a joint venture. Once itfound that the arrangement was a joint venture undersubstantive law, it ruled that it came within the federalstatutory definition of tax partnership. Nonetheless, bycreating qualified partnerships, the IRS relieved thosearrangements from the filing requirements established byCongress. By creating qualified partnerships, the IRSdisregarded the literal language of the code that includedjoint ventures in the definition of partnership. Instead, bytreating arrangements that do not have a joint profitmotive differently from arrangements that do, the IRSaccomplished the purpose the definition was intended toaccomplish — it treated different economic arrangementsdifferently.

In 1945 the IRS ruled that the partners, not thepartnership, may exercise the election to have the cuttingof timber (for sale or for use in the taxpayer’s trade orbusiness) considered as a sale or exchange of that timbercut during the tax year.40 That ruling appears to beinconsistent with later rulings (discussed below) thatrequire elections to be made at the partnership level.Perhaps the apparent inconsistency is justified under theinterdependence test that the IRS later established, whichis discussed below.

In 1948 the IRS again considered the proper entityclassification of certain oil and gas co-ownership-jointproduction arrangements.41 Although the IRS focused on

34Id.35Id.36I.T. 2749, XIII-1 C.B. 99 (1934).37Citing 47 C.J. 702. Those early rulings show that the IRS and

courts looked to substantive law to determine whether anarrangement constituted a partnership for federal income taxpurposes.

38I.T. 3930, 1948-2 C.B. 126, discussed below.39I.T. 2785, XIII-1 C.B. 96 (1934). The ruling allowed the

operating co-owner to file Form 1065 and an attached scheduleprovided by the IRS. The schedule was required to show the (1)total working interest, (2) names and addresses of the co-owners, (3) the percentage of each co-owner’s interest in theco-ownership, (4) total costs and expenses billed each co-owner

with respect to drilling for and producing oil and gas, and (5)the total revenue credited when the operating co-owner distrib-uted revenue to the other co-owners (by way of credit or cash)from the sale or other distribution of the co-owners’ oil and gas.

40I.T. 3713 1945 C.B. 178 (1945).41I.T. 3930, 1948-2 C.B. 126. The ruling listed several features

of typical operating agreements and ruled only on operatingagreements that contain such features. The features listed are:

(1) The costs of development and expenses of operationare to be prorated among the parties in accordance withtheir respective interests.(2) Division of oil proceeds is usually accomplished bypayment of the purchase price by the pipeline companyor other purchaser directly to the several parties inaccordance with their respective shares as indicated bydivision orders signed by them. Generally, any party maytake his share of the oil in kind. Where that right exists,any authority given the operator to market the oil may berevoked on proper notice. Sometimes, however, the op-erator is authorized without qualification to market theproduct.(3) The operator is required to carry adequate insuranceand to make an accounting.(4) Operating agreements remain in force until the min-eral is exhausted or, in the case of unit operating agree-ments, for the term of the lease or leases or renewalsthereof. Sometimes an express provision is made forwithdrawals thereof. Sometimes an express provision ismade from withdrawal of one of the parties by assign-ment of his rights to the others.(5) The parties having voting power proportionate totheir interests to choose and advise the operator (in casesin which only one lease is involved, broad powers arecommonly vested in the operator named in the agree-ment), to change the operator, to determine drilling and


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the federal tax distinction between a corporation and apartnership, its conclusion regarding the co-ownership-partnership question has been preserved. The IRS used afour-step analysis to rule that the arrangements were notcorporations but partnerships.

First, the IRS distinguished the subject agreementsfrom general partnerships ‘‘principally in that (1) theycan arise only between joint operators, (2) they extend toand are terminated by exhaustion of the mineral deposit,(3) the majority in interest controls policies, and (4) thedeath of a participant or the transfer of his interest doesnot interrupt the relation — the heir or transferee becom-ing a participant.’’

Second, the IRS recognized that an ‘‘organizationcarrying on business, financial operations, or ventures forthe joint profit of the associates [is] either a partnership ora corporation, depending on which of the two it morenearly resembles.’’ That statement appears to indicatethat both a joint profit motive and the carrying on of abusiness indicate the existence of either a partnership ora corporation, but does not distinguish them from eachother.

Third, the IRS identified two distinguishing attributesof associations: ‘‘[1] centralized management and [2]continuity of life.’’ Organizations ‘‘which do not havesuch attributes are comprehended by the term ‘partner-ship.’’’ The IRS stated that a separate personality or entityis immaterial in determining whether a business is acorporation or a partnership. The IRS ruled that thestatute required ‘‘all forms of unincorporated businessorganizations for joint profit [be treated as] partnershipsfor income tax purposes except those organizations[treated as associations].’’ Entities that attain ‘‘continuityof life and centralization of management . . . are by defi-nition associations classified as corporations.’’ Thus, theIRS established that any unincorporated entity withoutcentralized management and continuity of life was not anassociation, and any entity that possessed those at-tributes was an association.

Fourth, after establishing that centralized manage-ment and continuity of life distinguish tax corporationsfrom tax partnerships, the IRS disregarded those charac-teristics and focused on joint profit motive to rule that thearrangement was a partnership, not an association.42 In

doing so, the IRS first ruled that the sale of minerals —not the mere extraction of them — creates profits. Thatbeing the case, arrangements to extract minerals (at jointcost and expense to be met by contributions of therespective participants) do not evidence a joint profitmotive. Because the agreements ‘‘allow the participantsto take their shares of the mineral in kind (or provide forthe sale of the shares of the respective participants fortheir individual accounts under revocable agency pow-ers), the sale of the mineral, even though made by theoperator, is a sale by or on behalf of the individualparticipants.’’ Because there was no joint profit, the IRSclassified those arrangements as ‘‘qualified partner-ships,’’ meaning they were partnerships under the fed-eral statutory tax definition, but they did not have tofollow all of the general reporting requirements of part-nerships.

That ruling is odd because it classified an arrangementwith continuity of life and centralized management as apartnership, after stating that those were the two defin-ing characteristics of a corporation. The ruling is signifi-cant in that it created a standard that was relied on laterby the IRS in determining whether a partnership existsfor federal tax purposes. The standard that developedfrom this ruling is that an arrangement that (1) is not astate law corporation, (2) has sufficient businesslike ac-tivity, and (3) does not have a joint profit motive will beclassified as a partnership. Later, the absence of a joint-profit motive became important to co-ownership-jointproduction arrangements wishing to elect out of sub-chapter K under section 761(a)(2).43

In the ruling, the IRS also concluded that the partici-pants, through the qualified partnership thus created,‘‘individually owned depletable economic interests in theoil and gas in place and must report the proceedstherefrom as their income.’’ Thus, mixed with the illogicof the ruling that the arrangement was a partnership is asimultaneous disregard of the partnership for determin-ing ownership. That disregard has survived in somesections of the current tax law.44

The IRS reinforced its reliance on a joint profit motiveby stating that an operating agreement that irrevocablyvests the operator in his representative capacity with theauthority to extract and sell the mineral creates anassociation taxable as a corporation for federal incometax purposes. In such a situation, the association becomesthe owner of the oil and gas in place and of the incomederived therefrom. Thus, the sale of the oil and gas by theassociation creates profit for the association, not forindividuals. Under the ruling, those arrangements wouldbe corporations for tax purposes.

In 1953 the Tax Court decided whether an oil and gasarrangement was a partnership for purposes of electingto either deduct or capitalize intangible drilling costs.45

Originally the IRS did not allow the partnership to

operating plans, to audit and pass on the operator’saccounting, and to pass on transactions for disposal ofsurplus equipment.(6) Any party may sell or encumber his entire interest, butmay not subdivide or sell without giving the otherspreferential option (in the case of agreements coveringsingle leases, the contract may not contain express provi-sions to that effect).(7) The liabilities of the parties are to be separate and notjoint.42The IRS determined that the arrangements at issue created

centralized control in the majority interest or in the operatornamed to act for all. Because the life of those agreements is notinterrupted by the death of a participant nor by the transfer ofan interest, the organizations commonly treated by those agree-ments have continuity of life. Having two persons, the arrange-ments also met the association test.

43But see Madison Gas & Electric Co. v. Commissioner, 633 F.2d512 (7th Cir. 1980) (indicating that distributions of property inkind may be a form of profit sharing).

44See, e.g., section 1031(a)(2) (flush language).45Bentex Oil Corporation v. Commissioner, 20 T.C. 565 (1953).



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deduct intangible drilling costs in 1938 and 1939. Thetaxpayer contested the disallowance, contending that thelease agreement constituted a partnership and that thepartnership could elect to deduct the expenses. Thecontroversy was settled by allowing the deductions. Inlater years, the taxpayer individually elected to capitalizethe expenditures. Those expenditures were at issue in thecase before the Tax Court. The court did not accept eitherof the taxpayer’s arguments for capitalization in lateryears, namely that (1) the arrangement was not a part-nership or (2) that if it was a partnership, it was not ataxpayer for the purpose of making the election. On thefirst issue, the court found that the arrangement was ajoint venture or partnership, apparently under substan-tive law, and was therefore clearly within the broadstatutory meaning of tax partnership. On the secondissue, the court reasoned that the term ‘‘taxpayer’’ in-cluded passthrough entities that did not pay tax. Thus,the taxpayer was bound by the partnership election. Thatruling establishes that a partnership election can becontrolling regardless of the elections of individual part-ners.46

Those early co-ownership-joint production rulings es-tablish two general principles of the co-ownership-partnership question. First, the activity required by co-owners to extract or produce something from propertythey co-own is ‘‘substantially like the conduct of abusiness’’47 and therefore something more than mereco-ownership. Thus, those arrangements are partner-ships if they are not otherwise classified as corporations.Second, owners taking product from those arrangementsin kind, as opposed to causing the arrangements to sellthe product and divide the income therefrom among theco-owners, did not have a joint profit motive. A partner-ship without a joint profit motive was a qualified part-nership that could file a special schedule instead ofcompleting Form 1065, regardless of the substantive lawnature of the arrangement. Co-ownership-joint produc-tion arrangements that had activity substantially like theconduct of a business but distributed product in kind tothe co-owners were later able to make the section761(a)(2) election. The rulings also demonstrate the IRS’sand the courts’ willingness to disregard substantive lawin determining the reporting requirements of certainarrangements that are tax partnerships under the statu-tory definition. That deviation appears justified becausethe in-kind distribution of product raises accountingissues different from those present in an arrangemententered into for joint profit.

F. Family Partnerships

In proximity to those rulings, the Supreme Court alsoconsidered some family partnerships. Although thosecases do not address the co-ownership-partnership ques-tion directly, they have been cited extensively by courtsconsidering the co-ownership-partnership question and

deserve consideration. In the two leading cases, theSupreme Court ruled that a partnership was not createdwhen a husband transferred a portion of his businessassets to his wife who then contributed them to a statelaw partnership formed with the husband.48 The Court’sobjective in each case was to prevent the husband fromshifting income to his wife, who was not involved in theoperation or management of the husband’s businessenterprises.49 The Court relied on substantive law prin-ciples to disregard a state law partnership in each case.Citing two substantive law cases, the Court stated inTower that ‘‘[a] partnership is generally said to be createdwhen persons join together their money, goods, labor, orskill for the purpose of carrying on a trade, profession, orbusiness and when there is community of interest in theprofits and losses.’’50 The Court then focused on theintent of the parties, saying, ‘‘[w]hen the existence of analleged partnership arrangement is challenged by outsid-ers, the question arises whether the partners really andtruly intended to join together for the purpose of carryingon business and sharing in the profits and losses orboth.’’ Again citing substantive law cases, the Courtstated, the participants’ ‘‘intention in this respect is aquestion of fact, to be determined from testimony dis-closed by their ‘agreement, considered as a whole, and bytheir conduct in execution of its provisions.’’’51 It thenacknowledged that ‘‘this general rule should . . . apply intax cases where the government challenges the existenceof a partnership for tax purposes.’’ The Court thusadopted the substantive law intent test and ruled thatwhen the wife ‘‘does not share in the management andcontrol of the business, contributes no vital additionalservice, and where the husband purports in some way tohave given her a partnership interest, the Tax Court mayproperly take these circumstances into consideration indetermining whether the partnership is real within themeaning of the federal revenue laws.’’ The Court con-cluded ‘‘that while the partnership was ‘clothed in theouter garment of respectability’ its existence could not berecognized for income tax purposes.’’52

Although those cases were decided to prevent theassignment of income, they have been cited on numerous

46See also Rev. Rul. 54-42, 1954-1 C.B. 64.47The phrase ‘‘substantially like the conduct of a business’’

was later coined by the IRS in Rev. Rul. 68-344, 1968-1 C.B. 569(discussed below).

48See Commissioner v. Tower, 327 U.S. 280 (1946); Lusthaus v.Commissioner, 327 U.S. 293 (1946).

49‘‘And the wife drew on income which the partnershipbooks attributed to her only for purposes of buying and payingfor the type of things she had bought for herself, home andfamily before the partnership was formed. Consequently theresults of the partnership was a mere paper reallocation ofincome among the family members. The actualities of theirrelation to the income did not change.’’ Commissioner v. Tower,327 U.S. 291-2.

50The court cited Ward v. Thompson, 63 U.S. 330 (1859)(whether an arrangement between co-owners of a vessel was apartnership or charter arrangement for purposes of determiningjurisdiction of a court of admiralty), and Meehan v. Valentine, 145U.S. 611 (1892) (whether a lender became liable as a partner fordebts of a partnership based on the terms of the loan).

51The court cited Drenne v. London Assurance Company, 113U.S 51 (1885), and Cox v. Hickman, 8 H.L. Cas. 268 (1860).

52Lusthaus v. Commissioner, 327 U.S. 293 (1946) (citing the TaxCourt’s earlier decision at 5 T.C. 540).



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occasions in the partnership context. The reliance may bemisplaced, especially if facts in other cases differ signifi-cantly. Furthermore, much of the court’s discussion aboutintent draws from substantive partnership law. Thecourt’s reliance on substantive law in those family part-nership cases may not be helpful in addressing theco-ownership-partnership question because the facts areso different from a typical tenancy-in-common arrange-ment.

Not long after issuing the Tower decision, the SupremeCourt instructed the Tax Court to consider whethercertain family members had contributed capital or cur-rent services to a purported partnership.53 In that case,four sons used a note to buy an undivided one-halfinterest in a herd of cattle from their father and contrib-uted the interest to a partnership with their father, whocontributed his remaining one-half interest to the part-nership. Shortly after the partnership was formed in1940, two of the sons entered the army. The two youngersons went to school during the winter and worked withthe cattle during the summer. The taxpayers filed apartnership tax return for 1940 and 1941, but the TaxCourt, relying on Tower and Lusthaus, disallowed thedivision of income among the father and his sons basedon a finding that none of the sons had contributed capitalor services to the partnership. The Supreme Court in-structed the Tax Court to reconsider which of the sonshad ‘‘a bona fide intent [to] be partners in the conduct ofthe cattle business, either because of services to beperformed during those years, or because of contribu-tions of capital of which they were the true owners. . . . ’’Thus, intent clearly became important in the familypartnership context. Statutory changes in the law ad-dressed many of the issues that the Supreme Courtconsidered in those family partnership cases.54 Nonethe-less, the cases are frequently cited in cases consideringsignificantly different situations. In considering the co-ownership-partnership question, it appears better to rec-ognize that the focus on intent originated in the assign-ment of income context. For other situations outside thatcontext, more objective factors should be used.

G. Early Judicial ConsiderationsIn 1940 the Board of Tax Appeals considered whether

two brothers who co-owned, improved, and leased prop-erty were partners for federal income tax purposes.55 Theboard ruled that they were not partners, recognizing thata tenancy-in-common arrangement had never beforebeen classified as a partnership, even though the IRS hadformerly recognized the existence of tenancy-in-commonarrangements.56 Although the co-owners had developedthe property, the board stated that they did so at theinsistence of the lessee and the lessee operated theimprovements once constructed.57 The board was con-cerned that if it ruled that the tenancy in common were a

partnership, it would be difficult to exclude other ar-rangements — such as marital communities or tenanciesby the entirety — from the statutory definition of part-nership. Therefore, it ruled that no partnership existed.

The board predicted, with accurate foresight, that ‘‘itwould probably continue to be difficult to classify manyof the imaginable varieties of businesses and interests inwhich more than one person share.’’ The board statedthat the new statute ‘‘was intended primarily to providea more definite category for syndicates, and for organi-zations similar to them, to pools, and to joint ventures,the taxation of the income of which had been trouble-some.’’ According to the board, tenancy-in-common ar-rangements did not suffer from the same affliction,because income from simple co-ownership is easier tocompute. Because the co-ownership arrangement at issuedeveloped and leased property, the board’s concept ofsimple co-ownership was broad enough to encompasssome degree of business activity. The board, however, leftunanswered the question ‘‘[whether the same] could besaid as to income from the operation of a trade orbusiness by an organized group of tenants in common[,]’’suggesting that the degree of business operations oftenants in common should determine whether a partner-ship exists. In that discussion, the board recognizes thatthe broad definition of partnership enacted by Congresswas intended to address troublesome accounting issuesand that the definition did not include mere co-ownership of property, because mere co-ownership doesnot create troublesome accounting issues. It appears theboard realized that accounting issues become trouble-some for co-owners of property if they begin to activelyconduct business with the property.

In 1953 the Second Circuit ruled that a tenancy-in-common arrangement was not a partnership, eventhough the property was managed by a real estate agentwho accounted to the co-owners.58 The case was beforethe court because the taxpayer wished to deduct lossesfrom the sale of the property as capital losses to obtaincarryforward opportunities. If the taxpayer had beendeemed to be in a partnership with the other co-owners,the sale would have been of a partnership interest andthe loss would have been a capital loss. On the otherhand, the IRS took the position that there was no part-nership and the property was used in a trade or business,so the loss on the sale of the property should be ordinary.The court found that the agency’s regular and continuousactivity of maintaining the property in rental conditionand supplying those services for the tenants as wereneeded to rent them to good advantage fell within theconcept of a trade or business. The court found, however,that the co-owners had no intent to become partners, and

53Commissioner v. Culbertson, 337 U.S. 733 (1949).54Section 704(e).55Estate of Appleby v. Commissioner, 41 B.T.A. 18 (1940).56The court cited I.T. 1604 and I.T. 2082 for this proposition.57The two brothers each actively participated in all business

matters related to the property. They each signed leases; they

applied for insurance individually; tenants made checks pay-able to both brothers or to their father’s estate that weredeposited in a checking account they maintained in the name ofone of the brothers and paid bills from; two or three times ayear, they each drew an equal share of accumulations; they hadno office, stationery, or telephone in common; and they neverentered into a partnership agreement, held themselves out aspartners, or were so treated by others.

58Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953).


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it found that there was no partnership and that thetaxpayer disposed of property used in a trade or business(not a partnership interest), the loss from which consti-tuted ordinary income.

That decision is significant because it establishes thatthe co-owners, through their agent, were engaged in atrade or business, yet the business activity was notsufficient to create a partnership. The level of businessactivity engaged in by the co-owners was ‘‘[t]hat requirednot only [for] the maintenance of the eight buildings inrental condition but also the supplying of services for thetenants as were needed to rent them to good advantage.’’Thus, business activity by co-owners to (1) maintain theproperty in rental condition and (2) supply services fortenants as needed to rent the property to good advantageare not of the degree that creates a partnership.

III. The 1954 Code

Section 761 of the 1954 code introduced the electionout of subchapter K. That section duplicates the section7701 definition of ‘‘partnership’’ and creates electionsallowing partnerships to elect out of all or some of therules in subchapter K. Congress, however, did not dis-cuss the purpose for duplicating the definition or forenacting the election. One court indicated that section 761‘‘was enacted as congressional approval of the Bentexcase coupled with a recognition of the hardships causedby that decision.’’59 Later IRS rulings and court decisions,however, appear to interpret section 761 as a codificationof I.T. 3930 — arrangements that are partnerships undersection 7701 can elect not to report under subchapter Kbut may be treated as partnerships elsewhere in the code.

Section 761(a) allows the Secretary to prescribe regu-lations under which the members of an unincorporatedorganization can elect out of subchapter K if (1) theincome of the members of the organization may beadequately determined without the computation of part-nership taxable income and (2) it is availed of (A) forinvestment purposes only and not for the active conductof a business, (B) for the joint production, extraction, oruse of property, but not for the purpose of selling servicesor property produced or extracted, or (C) by dealers insecurities for a short period for the purpose of underwrit-ing, selling, or distributing a particular issue of securities.The regulations provide detailed requirements for eligi-bility to elect out of subchapter K.60 As provided in thestatute, the arrangement must be able to compute theowners’ income ‘‘without the necessity of computingpartnership taxable income.’’61 Also, the arrangementmust either be ‘‘[1] for investment purposes only and notfor the active conduct of a business, or [2] for the jointproduction, extraction, or use of property, but not for thepurpose of selling services or property produced orextracted.’’62

The regulations also provide additional requirementsfor each of these categories.63 For investment arrange-ments, the owners must ‘‘own the property as co-owners,reserve the right separately to take or dispose of theirshares of any property acquired or retained, and notactively conduct business or irrevocably authorize someperson or persons acting in a representative capacity topurchase, sell, or exchange such investment property,although each separate participant may delegate author-ity to purchase, sell, or exchange his share of any suchinvestment property for the time being for his account,but not for a period of more than a year.’’64

For co-ownership-joint production arrangements, theparticipants must ‘‘own the property as co-owners, eitherin fee or under lease or other form of contract grantingexclusive operating rights, reserve the right separately totake in kind or dispose of their shares of any propertyproduced, extracted, or used, and not jointly sell servicesor the property produced or extracted.’’65 There is aconsiderable body of law covering when a co-ownership-joint production arrangement qualifies for the section761(a)(2) election. On the other hand, there appears to beno body that considers when mere co-ownership ar-rangements qualify for the section 761(a)(1) election.

A. Qualifying for the Section 761 ElectionIn 1968 the IRS provided guidance regarding when a

co-ownership-joint production arrangement is eligiblefor the section 761 election.66 The arrangement at issuewas a group of electrical power corporations. Theyowned several large generating units as tenants in com-mon and had the right to take their respective shares ofpower generated and sell them to their respective end-users. The IRS relied on its analysis in I.T. 3930, whichwas published before the 1954 code was enacted, to rulethat the joint ownership and operation of the generatingunits was ‘‘substantially like the conduct of a business,’’but there was no division of profits because gain wasderived from sales of power by each participant for itsown account. Because the arrangement was not a trust,an estate, or a corporation, and was something more thana mere expense-sharing arrangement, the IRS ruled thatthe organization was a partnership. It then ruled thatbecause the participants satisfied all of the section761(a)(2) requirements ((1) they held title to the generat-ing units as tenants in common, and were co-owners; (2)

59Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521(1979).

60Treas. reg. section 1.761-2.61Treas. reg. section 1.761-2(a)(1).62Id.

63Treas. reg. section 1.761-2(a)(2) and (3).64Treas. reg. section 1.761-2(a)(2).65Treas. reg. section 1.761-2(a)(3) (there is a limited exception

to this third requirement, in that the regulation allows ‘‘eachseparate participant [to] delegate authority to sell his share ofthe property produced or extracted for the time being for hisaccount, but not for a period of time in excess of the minimumneeds of the industry, and in no event for more than 1 year.’’Treas. reg. section 1.761-2(a)(3)(iii). Additional rules apply toentities that produce natural gas under a joint operating agree-ment. Treas. reg. section 1.761-2(a)(3). Finally, an entity that hasas a principal purpose the ‘‘cycling, manufacturing, or process-ing for persons who are not members of the organization’’cannot elect out of subchapter K under Treas. reg. section1.761-2(a)(3). Id.).

66Rev. Rul. 68-344, 1968-1 C.B. 569.



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they actually took power in kind from the generatingunits, preserving the right to take production; and (3)they were able to adequately determine their respectiveincomes from the operation without computing partner-ship taxable income) the partnership could elect out ofthe subchapter K requirements.67

Because the result in that ruling was so similar to theresult in I.T. 3930, one could argue that the section761(a)(2) election was a codification of that ruling. Theend result of this ruling is that a partnership that qualifiesfor the section 761(a)(2) election does not have to adhereto the reporting requirements in subchapter K. An ar-rangement qualifies for the section 761(a)(2) election if itis a partnership that distributes property in kind (that is,it does not have a joint profit motive). That is the sameresult reached in I.T. 3930, in which the IRS ruled that aqualified partnership did not have to follow the generalpartnership reporting requirements but could instead filea simple schedule with the limited information. Based onother rulings and decisions following the enactment ofsection 761(a)(2), that appears to be the more correctinterpretation of the statute and its purpose.68

B. Effect of the Section 761 ElectionRev. Rul. 65-11869 demonstrates that the IRS did not

perceive section 761(a)(2) as alleviating the consequencesof Bentex. In that ruling, the IRS ruled that a joint ventureconsisting of four taxpayers, which owned an oil leaseand which was subject to a proper election under section761(a)(2), was still a tax partnership. The IRS ruled thatthe limit on the qualified investment credit for usedsection 38 property had to be determined at the partner-ship level. Thus, the section 761(a)(2) election did notaffect the treatment of the investment credit; it merelyrelieved the partnership of subchapter K reporting.

In Rev. Rul. 83-129,70 the IRS ruled that members of anoil and gas operation that made the section 761(a)(2)election could individually make the election undersection 616(b) to defer shares of the property’s develop-ment cost. Thus, one member was able to deduct theexpenses on a ratable basis as the units of minerals weresold, and the other member was allowed to deduct itsshare of the development costs in the fourth year. Thelack of analysis in the ruling does not explain why theIRS allowed the partners to make the election individu-ally. The Tax Court stated earlier, however, that ‘‘[t]heelection under section 761(a) does not operate to changethe nature of the entity. A partnership remains a partner-ship; the exclusion simply prevents the application ofsubchapter K. The partnership remains intact and othersections of the Code are applicable as if no exclusionexisted.’’71 Based on that rule of law, the Tax Court heldthat the limitation on the amount of investment credit is

computed at the partnership level, not by each partner.The Tax Court therefore adopted the IRS’s position asstated in Rev. Rul. 65-118.72 The IRS attempted to explainthe apparent inconsistency in a memorandum publishedin 1977.

The IRS established a standard for determiningwhether a partnership that elects to be excluded from theprovisions of subchapter K under section 761(a) shouldcontinue to be treated as a partnership for purposes of thecode outside of subchapter K.73 The IRS stated that, if aparticular section of the code is ‘‘interdependent’’ withsection 761(a), the partnership should not be treated as apartnership for purposes of that section. On the otherhand, if a section of the code is not interdependent withsection 761(a), the partnership should continue to betreated as a partnership for purposes of such section. In alater memorandum, the IRS further elaborated on theinterdependence test by concluding that ‘‘whether apartnership that elected out of subchapter K should betreated as a partnership for other code provisions isbased on whether continuing to treat a partnership thatelects out of subchapter K as a partnership would beconsistent with the purpose and effect of section761(a).’’74 Thus, the IRS concluded that some provisionsoutside of subchapter K, such as section 48(c)(2)(D), arenot interdependent with section 761(a) because:

it is not inconsistent with the purpose and effect ofsection 761(a) to continue to recognize the partner-ship as such for purposes of the investment creditlimitation. Merely because a partnership elects not

67Treas. reg. section 1.761-1(a)(2)(iii).68See also Rev. Rul. 56-500, 1956-2 C.B. 464 (the sale of an

interest in the property does not affect the section 761(a)(2)election).

69Rev. Rul. 65-118, 1965-1 C.B. 30.70Rev. Rul. 83-129, 1983-2 C.B. 105.71Olin Bryant v. Commissioner, 46 T.C. 848 (1966). The taxpay-

ers did not dispute the existence of a partnership as defined in

sections 761(a) and 7701(a)(2), so there is no discussion aboutwhat constitutes a partnership for tax purposes.

72The court made three statements of law about the section761 election:

First, the election provided for in section 761(a) is re-stricted by its own tight and explicit terms to subchapterK and it does not otherwise affect the treatment orcharacter of the business relationships of petitioners.Second, . . . [t]he term ‘‘partnership’’ is defined in section761(a) ‘‘for the purposes of this subtitle.’’ Thus the samemeaning must be given to the term ‘‘partnership’’ insection 761 and 48 since both are part of subtitle A of theCode.Third, the Commissioner is empowered by section 761(a)to exclude a partnership ‘‘from the application of all or apart of this subchapter.’’ Such exclusion from partnershiptreatment is expressly limited by the plain language of thestatute. The Commissioner does not have the authority toredefine what a partnership is; he is only empowered toexclude partners from being treated as such under onespecific subchapter. If we are to accept the argumentadvanced by petitioners, we would necessarily extend theCommissioner’s power of exclusion to other sections ofthe Code outside subchapter K. This we are unwilling todo because it would not be within the spirit or intend-ment of the statute as enacted by Congress. In ouropinion sections 761(a) and 48(c)(2)(D) are not interde-pendent. When Congress has subtitlized, subchapterized,and sectionized its treatment of a many threaded statu-tory pattern like the complex Internal Revenue Code, itsclear words seem to us a safe guide to meaning.73GCM 36982 (Jan. 13, 1977).74GCM 39043 (Aug. 5, 1983).




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to be subject to the provisions of subchapter K doesnot mean that the partnership can escape limita-tions generally applicable to partnerships if thoselimitations can be applied despite the fact thatincome and deductions are computed at the partnerrather than the partnership level. The question ineach instance is whether the limitation or ruleoutside of subchapter K can be applied withoutdoing violence to the concept of electing out ofsubchapter K and computing income and deduc-tions at the partner level.

That interdependence test may help explain whydifferent partnerships that elect out of subchapter K aretreated differently throughout the code. The differenttreatment throughout the code is important to considerwhen evaluating how best to address the co-ownership-partnership question. If addressed in section 761, theco-owners would have to consider the possible implica-tions of other sections of the code.

IV. Classifying Unincorporated ArrangementsNeither the 1954 code nor the regulations promul-

gated after its enactment solved the co-ownership-partnership question. Taxpayers, the IRS, and the courtscontinue to struggle with the question. Developmentsfollowing the enactment of the 1954 code reveal that fora time the IRS and courts continued to look to substantivelaw to determine whether a partnership existed. Later,however, the IRS appeared to completely disregard thesubstantive law definition of partnership, leaving thequestion to be answered solely under tax laws.

A. The Original Section 761 RegulationsIn regulations promulgated under section 761 shortly

after enactment of the 1954 code, the IRS stated, ‘‘[t]heterm ‘partnership’ is broader in scope than the commonlaw meaning of partnership, and may include groups notcommonly called partnerships. See section 7701(a)(2).’’75

In that provision, the IRS was specifically referring to thedefinition of partnership found in section 7701(a)(2). Asdiscussed above, Congress adopted that definition toexpand the application of the partnership reporting re-quirements so they would also apply to substantive lawjoint ventures, syndicates, groups, and other unincorpo-rated organizations. It appears, based on the IRS’s citingto section 7701(a)(2), that it was not saying that substan-tive law should be disregarded in determining whether apartnership exists for federal income tax purposes. In-stead, it appears the IRS was saying that substantive laworganizations, such as joint ventures, syndicates, pools,and groups were indeed partnerships for federal incometax purposes.76 Based on those regulations, it appearsthat in 1956, the IRS would still look to the substantive

law characterization of an arrangement to determine if afederal tax partnership existed.

In the 1956 regulations, the IRS also specifically pro-vided that two types of arrangements do not fall withinthe definition of partnership for federal income taxpurposes. First, the IRS excluded expense-sharing ar-rangements from its definition of partnership: ‘‘For ex-ample, if two or more persons jointly construct a ditchmerely to drain surface water from their properties, theyare not partners.’’77 While there appears to be littleguidance about the scope of that arrangement, the co-ownership-joint production cases and rulings providesome insight. Earlier, the IRS coined the phrase ‘‘substan-tially like the conduct of business.’’78 In co-ownership-joint production cases, the parties co-owned and oper-ated property that produced a product that the partiesreceived in kind and marketed individually. Producing aproduct requires businesslike activity. While the actualactivity required to jointly produce a product may notdiffer significantly from the activity required to jointlydig a ditch, joint production differs from ditch digging inthat joint production results in a product that the co-owners can sell. It appears that those co-ownership-jointproduction arrangements do not qualify as mereexpense-sharing arrangements, because something isproduced and distributed to the co-owners. The lack ofjoint profit motive, however, distinguishes co-ownership-joint production arrangements from partnerships thatcannot elect out of subchapter K. Thus, joint productionestablishes that the arrangement is a partnership. Thelack of profit motive (that is, the in-kind distribution ofproduct) establishes that the partnership can elect out ofsubchapter K.

Second, the IRS excluded mere co-ownership of prop-erty from its definition of partnership.79 That exceptionallows co-owners to maintain, keep in repair, and rent orlease property without being treated as a partnership.The example provided for that exception allows anindividual owner or tenants in common to lease farmproperty to a farmer for cash or a share of the crops.Perhaps that is an adoption of the IRS’s earlier tenancy-in-common ruling that tenants in common of a farm werenot partners.80

The IRS definition of partnership under the 1956regulations also provides that if tenants in commonactively carry on a trade, business, financial operation, orventure and divide the profits thereof, they may bepartners. For example, if co-owners of an apartmentbuilding lease space and provide services to the occu-pants, either directly or indirectly through an agent, theyform a partnership. Thus, the IRS adopted the previouslyarticulated standard that the mere co-ownership excep-tion depends on the degree of business activity that theco-owners conduct, directly or through an agent. As theSecond Circuit held, co-ownership is not a partnership ifthe level of business is not more than the regular and

75Treas. reg. section 1.761-1(a)(1) (1956), T.D. 6175, (May 23,1956).

76Id. (‘‘The term ‘partnership’ includes a syndicate, group,pool, joint venture, or other unincorporated organizationthrough or by means of which any business, financial operation,or venture is carried on, and which is not a corporation or a trustor estate within the meaning of the Code.’’).

77Treas. reg. section 1.761-1(a)(2) (1956).78Rev. Rul. 68-344, 1968-1 C.B. 569.79Treas. reg. section 1.761-1(a)(1) (1954).80See I.T. 1604, II-1 C.B. 1 (1923).



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continuous activity of maintaining the property in rentalcondition and supplying services for the tenants as wereneeded to rent the property to good advantage.81 There-fore, a partnership does not exist if services provided bythe co-owners are essential to leasing the property.82 If,however, the services are not needed to rent the propertyto good advantage, performing those additional servicescreates a partnership.

B. A Potpourri of Cases and Rulings

Following the enactment of section 761, the IRS andseveral courts considered the co-ownership-partnershipquestion and whether a partnership existed for tax pur-poses in other situations. The disparity of facts and seem-ingly inconsistent rulings make those cases difficult toreconcile. In some situations, the courts and the IRS ruledthat no partnership existed for federal tax purposes;83 inothers, they ruled that a partnership did exist for federaltax purposes.84 The cases and rulings consider whether anarrangement is a partnership for federal tax purposes oris one of the following: (1) a co-ownership of property;85

(2) an employee-employer relationship;86 (3) a debtor-creditor relationship;87 (4) a family income-shifting ar-rangement;88 or (5) an oil and gas, electrical, mining, orsimilar joint operation.89 The IRS and courts have not beenparticular in identifying prior case law with similar factswhen drawing on precedent.90 Some courts cite no au-thority or appear to rule based on the plain language of

81See Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953).82See also Rev. Rul. 75-374, 1975-2 C.B. 261 (ownership as

tenants in common not a partnership where co-owners providecustomary tenant services through an agent but do not share inrevenue from noncustomary services provided to the tenants).

83Joe Balestrieri & Co. v. Commissioner, 177 F.2d 867 (9th Cir.1949); Coffin v. U.S., 120 F. Supp. 9 (S.D. Alabama 1954); Hahn v.Commissioner, 22 T.C. 212 (1954); Rev. Rul. 56-500, 1956-2 C.B.464; Luna v. Commissioner, 42 T.C. 1067 (1964); McShain v.Commissioner, 68 T.C. 154 (1977); Rev. Rul. 75-374, 1975-2 C.B.261; Ian T. Allison, T.C. Memo. 1976-248, 35 T.C.M. (CCH) 1069(1976).

84Luckey v. Commissioner, 334 F.2d 719 (9th Cir 1964); Rev. Rul.68-344, 1968-1 C.B. 569; Podell v. Commissioner, 55 T.C. 429 (1970);S&M Plumbing Co. v. Commissioner, 55 T.C. 702 (1971); LTR7919065 (Feb. 12, 1979); Estate of Levine v. Commissioner, 72 T.C.780 (1979); Underwriters Ins. Agency of America, T.C. Memo.1980-92, 40 T.C.M. (CCH) 5 (1980); LTR 8315003 (July 17, 1982);Bussing v. Commissioner, 88 T.C. 449 (1987); Bussing v. Commis-sioner, 89 T.C. 1050 (1987); William G. Alhouse, T.C. Memo.1991-652, 62 T.C.M. (CCH) 1678, 91 TNT 264-29 (1991); Bergfordv. Commissioner, 12 F.3d 166, Doc 94-368, 93 TNT 264-10 (9th Cir.1993).

85See, e.g., I.T. 1604, II-1 C.B. 1 (1923) (co-ownership of farmnot a partnership); I.T. 2082, III-2 C.B. 176 (1924) (co-ownershipof property and retail merchandise business not a partnership);Estate of Appleby v. Commissioner, 41 B.T.A. 18 (1940) (tenancy-in-common arrangement not a partnership); Gilford v. Commis-sioner, 201 F.2d 735 (2d Cir. 1953) (tenants in common notpartners); Coffin v. U.S., 120 F. Supp. 9 (S.D. Alabama 1954)(tenancy-in-common arrangement not a partnership); Hahn v.Commissioner, 22 T.C. 212 (1954) (tenancy-in-common arrange-ment not a partnership); Luckey v. Commissioner, 334 F.2d 719(9th Cir. 1964) (acquisition, development, and disposition bytenants in common a partnership); McShain v. Commissioner, 68T.C. 154 (1977) (co-ownership of triple-net leased property not apartnership); Podell v. Commissioner, 55 T.C. 429 (1970) (acquisi-tion, renovation, and disposition of properties a partnership);Rev. Rul. 75-374, 1975-2 C.B. 261 (ownership as tenants incommon not a partnership where co-owners do not share inrevenue from noncustomary services provided to tenants);Estate of Levine v. Commissioner, 73 T.C. 780 (1979) (extent ofservices tenants in common provided to tenants created a

partnership); Underwriters Ins. Agency of America, T.C. Memo.1980-92, 40 T.C.M. (CCH) 5 (1980) (co-ownership was a partner-ship where participants treated it as such for federal taxpurposes); Bussing v. Commissioner, 88 T.C. 449 (1987)(computer-leasing arrangement a partnership); Bussing v. Com-missioner, 89 T.C. 1050 (1987) (computer leasing arrangement apartnership); William G. Alhouse, T.C. Memo. 1991-652, 62 T.C.M.(CCH) 1678 (1991) (computer leasing arrangement a partner-ship); Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993)(computer leasing arrangement a partnership).

86See, e.g., Bartholomew v. Commissioner, 186 F.2d 315 (8th Cir.1951) (out-of-state engineer not a partner) and Luna v. Commis-sioner, 42 T.C. 1067 (1964) (agreement between insurance com-pany and agent not a partnership).

87See, e.g., Joe Balestrieri & Co. v. Commissioner, 177 F.2d 867(1949) (A guarantee did not make guarantor a partner.); S&MPlumbing Co. v. Commissioner, 55 T.C. 702 (1971) (contributionwas to a partnership); Ian T. Allison, T.C. Memo. 1976-248, 35T.C.M. (CCH) 1069 (1976) (no partnership where lender receivedfixed-fee for financing subdivision).

88See, e.g., Commissioner v. Tower, 327 U.S. 280 (1946) (husbandand wife not a partnership); Lusthaus v. Commissioner, 327 U.S.293 (1946) (husband and wife not a partnership); Commissioner v.Culbertson, 337 U.S. 733 (1949) (A father and son cattle operationcould be a partnership.).

89See, e.g., I.T. 2749, XIII-1 C.B. 99 (1934) (co-ownership of oiland gas property a partnership); I.T. 2785, XIII-1 C.B. 96 (1934)(co-ownership of oil and gas could file an information return.);I.T. 3713, 1945 C.B. 178 (timber cutting operation a partnership);I.T. 3930, 1948-2 C.B. 126 (co-ownership and operation of oil andgas property a partnership); Bentex Oil Corporation v. Commis-sioner, 20 T.C. 656 (1953) (co-ownership and operation of oil andgas property a partnership); Rev. Rul. 54-42 1954-1 C.B. 64(co-ownership and operation of oil and gas property a partner-ship); Rev. Rul. 65-118, 1965-1 C.B. 30 (co-ownership and opera-tion of oil and gas property a partnership); Rev. Rul. 68-344,1968-1 C.B. 569 (co-ownership and operation of power generat-ing units a partnership); Rev. Rul. 83-129, 1983-2 C.B. 105(mineral lease); Rev. Rul. 56-500, 1956-2 C.B. 464 (joint extractionoperations); Rev. Rul. 68-344, 1968-1 C.B. 569 (co-ownership andoperation of electric generating units a partnership); LTR7919065 (Feb. 12, 1979) (co-ownership and operation of nucleargenerating plant a partnership); LTR 8315003 (June 17, 1982)(operation of a mine a partnership).

90See, e.g., Bartholomew v. Commissioner, 186 F.2d 315 (8th Cir.1951) (employment versus partnership case in which the courtcited family income assignment case as precedent); S&M Plumb-ing Co. v. Commissioner, 55 T.C. 702 (1971) (financing versuspartnership case in which the court cited a co-ownership case(Podell)); Ian T. Allison, T.C. Memo. 1976-248, 35 T.C.M. (CCH)1069 (1976) (co-ownership versus partnership case in which thecourt cited a family income assignment case (Culbertson) and afinancing versus partnership case (S&M Plumbing)); Estate ofLevine v. Commissioner, 72 T.C. 780 (1979) (co-ownership versuspartnership case in which the court cited family assignment ofincome cases (Tower and Culbertson)); Underwriters Ins. Agency ofAmerica, T.C. Memo. 1980-92, 40 T.C.M. (CCH) 5 (1980) (co-ownership versus partnership case in which the court cited


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the statute.91 In some cases, the courts looked at whetherthe parties intended to form a partnership, but in others,the courts said that intent was not relevant. With all ofthose cases, it is evident that guidance is needed. Theseveral tests outlined above, if adopted by the IRS andused consistently by the courts, would provide guidancein this area of the law. Those tests would have to beadjusted a little by a few relatively recent rulings.1. The diminished importance of joint profit motive. Atone point, the lack of joint profit motive appeared to beimportant in determining whether a co-ownership-jointproduction arrangement could make the section 761(a)(2)election, but Madison Gas & Electric Co. v. Commissioner92

places that principle in doubt. That case involved atypical co-ownership-joint production arrangement inwhich one co-owner wished to deduct certain employeetraining expenses related to a co-owned electricity plant.The IRS took the position that the expenses were incurredin the start-up of a new partnership and therefore werenot deductible currently. The court rejected the taxpayer’sargument that there must be a joint profit motive for apartnership to exist under the sections 7701 and 761definitions. It ruled alternatively that if a joint profitmotive is required, ‘‘[t]he difference between the marketvalue of MGE’s share of that electricity and MGE’s shareof the costs of production obviously represents a profit.’’Thus, the court found that the arrangement was a part-nership under the definition in sections 7701 and 761.

The court did not consider the validity of the partner-ship’s section 761(a)(2) election. It did, however, indicatethat its decision does not affect the partnership’s abilityto make the election. It quoted the Tax Court, stating, ‘‘[i]fdistribution in kind of jointly produced property wasenough to avoid partnership status, we do not see howsuch distribution could be used as a test for election to beexcluded from the partnership provisions of subchapterK.’’ Thus, the Seventh Circuit might have killed the jointprofit motive test, but it replaced it with a distributionin-kind test. Now it appears that co-ownership-jointproduction arrangements can elect out of subchapter K ifproperty that is produced jointly is distributed to theco-owners in kind. It appears there is no longer a need todetermine if the arrangement has a joint profit motive.2. Another test for mere co-ownership. The computerleasing cases of the 1980s and 1990s appear to addanother principle to the co-ownership-partnership ques-tion.93 In those cases, investors borrowed money from an

unrelated party (the manager) and used it and personalmoney to acquire undivided interests in computer equip-ment. Then they triple-net-leased the equipment to an-other party. The manager arranged to lease the propertyand performed all other activities necessary to lease theproperty. The investors merely invested money.

Because the IRS cites Bergford v. Commissioner exten-sively in Rev. Proc. 2002-22,94 the case takes on particularsignificance. In that computer leasing case, the NinthCircuit ruled that a partnership did exist, but instead offocusing on the level of business activity of the arrange-ment, the court focused on (1) the contributions of thevarious parties, (2) the source of the parties’ economicbenefit, and (3) the parties’ ability to partition out aninterest in the underlying property.95 Regarding the firstfactor, the court noticed that the investors contributedcapital and the manager contributed services, indicatingthat a partnership existed. The court also concluded thatthe Tax Court did not err in finding that the ‘‘economicbenefits to the individual participants were not deriva-tive of their co-ownership of the computer equipment,but rather from their joint relationship toward a commongoal.’’

Those two factors appear to add a new dimension tothe co-ownership-partnership question. They establishthat a mere co-ownership does not exist if parties jointogether with some contributing capital and some con-tributing services. In those computer leasing cases, thecourts found that both the investors and the managershad a stake in the profits and losses of the arrangement.Thus, the parties contributed capital and services to theventure with the expectation of making a profit off thecombined use of the capital and services. That type ofarrangement can be distinguished from the arrangementin Gilford, in which the co-owners hired a real estate agentto lease the property, presumably under a traditionalbrokerage arrangement, that is, the agent was most likelypaid based on gross rents or a fixed amount, not the netincome of the property. There is no evidence that themanager in the computer leasing cases provided morethan those services necessary to keep the property inrental condition and rent it to good advantage. Therefore,the combination of capital and services and the sharing ofprofits with a service provider distinguishes the com-puter leasing cases from other co-ownership cases, suchas Gilford.

The computer leasing cases also introduce the conceptof the source of the economic benefit of the arrangement.In those cases, the courts found that the investors’economic benefit did not derive solely from the soleownership of property, but from a joint relationshiptoward a common goal. Thus, it appears that to qualify asa mere co-ownership, the economic benefit of the co-owners must derive solely from the ownership of the

family assignment of income cases (Tower and Culbertson) andan employment case (Luna); Bussing v. Commissioner, 88 T.C. 449(1987) (computer leasing case in which the court cited familyassignment of income cases (Tower and Culbertson); William G.Alhouse, T.C. Memo. 1991-652, 62 T.C.M. (CCH) 1678 (1991)(computer leasing case listing the factors from an employmentcase (Luna); Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993)(computer leasing case in which the court cited an employmentcase (Luna), an electrical cooperative case (Madison Gas &Electric), and a family assignment of income case (Tower)).

91See, e.g., Gilford v. Commissioner, 201 F.2d 735 (2d Cir. 1953).92633 F.2d 512 (7th Cir. 1980).93Bussing v. Commissioner, 88 T.C. 449 (1987); Bussing v.

Commissioner, 89 T.C. 1050 (1987); William G. Alhouse, T.C.

Memo. 1991-652, 62 T.C.M. (CCH) 1678 (1991); Bergford v.Commissioner, 12 F.3d 166 (9th Cir. 1993).

94See section 2.95This third factor reflects courts’ focus on substantive law

and adds nothing new to the co-ownership-partnership ques-tion.




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property. It is unclear from the ruling whether the courtwas adding a new principle or merely restating the rulethat an arrangement is not a mere co-ownership if itsbusiness activity exceeds a certain level. It is possible thateconomic benefit derives solely from the property if theservices provided by the co-owners are limited to thoserequired to maintain the property in rental condition andrent it to good advantage. Any services provided beyondthat, for compensation, would produce an economicbenefit derived solely from something other than theproperty. Furthermore, with respect to the manager,because the manager contributed only services, its eco-nomic benefit can arise only from those services. To theextent the manager shares in the rental profits, thatsharing is an economic benefit of one of the participantsthat derives from services, not the property.

The court’s focus on the co-owners’ inability to parti-tion the property is a reliance on the substantive lawdefinition of tenancy in common, which by defaultwould not be a partnership for federal tax purposesbecause it is not within the statutory definition. Thataspect of the case is important to the extent substantivelaw still influences the co-ownership-partnership ques-tion. If substantive law no longer affects the question, thesole focus would be on ensuring that uniform accountingand reporting requirements apply to all taxpayers insimilar economic situations. Co-owners who all contrib-ute only capital to acquire interests in property andderive economic benefits solely from the co-owned prop-erty, should not be required to comply with accountingand reporting requirements that apply to arrangementsthat derive economic benefit from sources other thanownership of property. The ability or inability to partitionproperty and other substantive law characteristics mayaffect the value of the interest owned, but appear to beirrelevant if the focus is on the economic aspects of anarrangement and the source of economic benefit.

3. Election into partnership classification. More re-cently the Tax Court appeared to disregard the testsoutlined above to hold that a co-ownership arrangementwas a partnership for federal tax purposes. In Tim H.Cusick,96 the co-owners provided some services to main-tain their property, such as fixing backed-up toilets andassisting tenants who were locked out of their offices, butthey appeared to do nothing beyond what was requiredto maintain the property in rental condition and rent it togood advantage. The co-owners kept books and main-tained an account for the arrangement, but did not file apartnership tax return. The only aspect of the arrange-ment that may distinguish it from other arrangementsthat were held not to be partnerships was the co-owners’testimonies that they intended for the arrangement to bea partnership. Because there appeared to be no businessactivity beyond that required to maintain the property inrental condition and rent it to good advantage, thedecision appears to provide co-owners the option to electto be treated as a partnership if their arrangement would

otherwise not be treated as a partnership.97 Cusick there-fore appears to provide an election into partnershipclassification.

C. Current Section 7701 RegulationsThe current regulations under section 7701 (the check-

the-box regulations) provide a bright-line test for deter-mining whether a separate entity is a partnership orcorporation, but still largely do not answer what consti-tutes a separate entity. The regulations provide a multi-step process for determining entity classification. Thepreamble to the regulations provides that ‘‘[t]he first stepin the classification is to determine whether there is aseparate entity for federal tax purposes.’’98 If a separateentity exists, the second step is to determine whether it isa partnership, corporation, or trust.99 The questionwhether a separate entity is a corporation has beenlargely answered.100 Although the definition of trust doesnot appear to be fully evolved,101 the most significantquestion in the co-ownership-partnership question iswhether a separate entity exists. The check-the-box regu-lations modified the definition of partnership that for-merly appeared in the section 761 regulations.102 Underthe new rules, if a separate entity does not exist, anarrangement with multiple owners will not be a taxpartnership. If a separate entity with multiple ownersdoes exist, it will be a partnership, corporation, ortrust.103 Thus, the primary question under the currentrules is whether an arrangement is a separate entity.1. Regulatory definition of separate entity. The IRSlargely adopts as its definition of separate entity thedefinition it used in the former section 761 regulations todefine partnership.104 For example, the IRS provides that‘‘[a] joint venture or other contractual arrangement maycreate a separate entity for federal tax purposes if theparticipants carry on a trade, business, financial opera-tion, or venture and divide the profits therefrom.’’ Thatsame language was used in the old section 761 regula-tions to define partnership. Otherwise the check-the-boxregulations adopt the examples used in the old section761 regulations definition of partnership for the currentdefinition of separate entity. Therefore, the tests dis-cussed above appear to apply in determining whether aseparate entity exists under the check-the-box regula-tions. The only primary difference between the definitionof partnership in the old section 761 regulations and the

96T.C. Memo. 1998-286, 76 T.C.M. (CCH) 241 (1998).

97The court discussed the level of business activity, stating,‘‘[t]he regulations and relevant case law indicate that thedistinction between mere co-owners and co-owners who areengaged in a partnership lies in the degree of business activityof the co-owners or their agents.’’ Because the degree ofbusiness activity appeared to be so low, however, it appears thatwas not the basis of the court’s decision.

98T.D. 8697 (Dec. 17, 1996).99Treas. reg. section 301.7701-2(a).100Treas. reg. sections 301.7701-2(b) and -3.101Rev. Rul. 2004-86, 2004-33 IRB 191.102The definition of partnership the section 7701 regulations

is now adopted by reference in the section 761 regulations. SeeTreas. reg. section 1.761-1(a)(1) (2005).

103Treas. reg. section 301.7701-2(a), -2(c), -3(a).104Treas. reg. section 301.7701-1(a)(2).



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definition of separate entity in the check-the-box regula-tions is that the current definition disregards substantivelaw.2. Current relevance of substantive law. The definitionof separate entity in the check-the-box regulations doesdiffer significantly from the definition of partnership inthe old section 761 regulations in its disregard of substan-tive law. The preamble to the check-the-box regulationsprovides that ‘‘[t]he regulations explain that certain jointundertakings that are not entities under local law maynonetheless constitute separate entities for federal taxpurposes; however, not all entities formed under locallaw are recognized as separate entities for federal taxpurposes.’’105 In promulgating that new rule, the IRSappears to have removed the state law definition ofpartnership from the determination of whether a partner-ship exists. That disregard of substantive law is a signifi-cant departure from the old rule under section 761 thatappeared to rely to a large extent, on the substantive lawdefinition of partnership to answer the co-ownership-partnership question.

That definition under the check-the-box regulationsraises the question of whether a state-law entity withmultiple owners that is formed to conduct an expense-sharing arrangement or merely own property can bedisregarded for federal tax purposes, if that entity is nota corporation. For example, if two parties form a limitedliability company to dig a ditch, can the arrangement bean expense-sharing arrangement or will it be treated as aseparate entity? Or can two individuals retain theirco-ownership status if they contribute co-owned rawland to a limited liability company and continue to holdit for investment? The language in the preamble to thecheck-the-box regulations and the language of the regu-lations appear to indicate that such is possible. Thatconclusion is not inconsistent with case law that disre-gards substantive law in ruling that a partnership existsor does not exist for federal tax purposes. Indeed, thatconclusion is also consistent with the original purpose forenacting a definition of partnership: namely, to requireindividuals that were similarly situated to be subject tothe same reporting requirements. As case law demon-strates, the level of business activity, not substantive law,distinguishes the different arrangements from an ac-counting and reporting perspective. Although the origi-nal statutory definition and early case law appears tohave put significant weight on the substantive law defi-nition of partnership, it is now clear that the focus was tosubject people in similar economic situations to similarreporting requirements. Choice of substantive law entitydoes not necessarily affect the economic situation ofparticipants. The IRS appears to have acknowledged thisat some level by disregarding substantive law and focus-ing on the economic arrangement in the check-the-boxregulations.106 Thus, the principles established above, not

substantive law, arguably should govern the co-ownership-partnership question.

D. Section 761(a)(1) Election

Although several cases consider whether an arrange-ment is a mere co-ownership or a partnership, thereappear to be no cases that consider whether a co-ownership arrangement that is a partnership under thesection 7701 regulations can elect out of subchapter Kunder section 761(a)(1). The regulations under section761(a)(1) require that co-owners who wish to elect out ofsubchapter K to (1) own the property as co-owners, (2)reserve the right separately to take or dispose of theirshares of any property acquired or retained, and (3) notactively conduct business or irrevocably authorize anagent to sell or exchange the property. As the case lawdiscussed above demonstrates, an arrangement that sat-isfies all of those requirements would not have been apartnership under the definition in the old section 761regulations. Similarly, an arrangement that satisfies thethree requirements under the section 761(a)(1) regula-tions will not be a partnership under the check-the-boxregulations. Thus, it is difficult to contemplate a set ofcircumstances to section 761(a)(1) will be relevant wherethe business activity is enough to be a separate entity butnot enough to forgo eligibility for a section 761(a)(1)election out of subchapter K. That fact strongly suggeststhat to the extent a state-law entity is to be disregarded indetermining whether an arrangement is a co-ownership,the proper place to disregard the state-law entity is in thedefinition of separate entity in the check-the-box regula-tions.

VI. The Co-Ownership-Partnership Test

The co-ownership-partnership question has been aconundrum for close to 100 years. From the great body ofcase law and IRS rulings that cover that question, a fewgeneral principles can be derived that should be used totest whether an arrangement is a co-ownership or apartnership. The general principles apply to two generaltypes of co-ownership arrangements: (1) co-ownership-joint production arrangements and (2) mere co-ownership arrangements. The principles governing co-ownership-joint production arrangements seem fairlywell established. Those arrangements are partnershipsunder the general definition of partnership in sections7701 and 761. If those partnerships distribute their pro-duction in kind to the co-owners, they can elect out ofsubchapter K.

The principles governing mere co-ownership arrange-ments are not as well established, but they do have someform. First, the test for determining whether a mereco-ownership exists depends primarily on the degree ofbusiness activity conducted by the co-owners or theiragents. That business activity cannot exceed that requiredto maintain the property in rental condition and rent it togood advantage. Second, to be a mere co-ownership, theco-owners’ economic benefit must derive from the prop-erty, not from business activity. A service provider whoreceives a percentage of the net profit of the arrangementderives economic benefit from the services, not theproperty. Also, if the services generate income other than

105T.D. 8697 (Dec. 17, 1996).106The recognition of the Delaware statutory trust as a

separate entity in Rev. Rul. 2004-86, 2004-33 IRB 191, indicatesthat the IRS does not currently read the regulations this literally.



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rental income, economic benefit derives from those ser-vices. Third, the contribution of property and services toa common goal indicates that the arrangement is morethan a mere co-ownership. Both property and services arecontributed to a common goal if some parties whocontribute capital and others who contribute services allshare in the net profits of the arrangement.

Finally, the check-the-box regulations reveal that sub-stantive law now has a reduced impact on the co-ownership-partnership question. That development is ap-propriategiventhepurposeofthepartnershiprulesandthedevelopments in substantive law. The cases and rulingsthataddress theco-ownership-partnershipquestiondonotappear to have relied on the substantive law definitions ofco-ownershipandpartnershipinaconsistentmannerorforany purpose other than to identify arrangements that fellwithin the statutory definition of tax partnership. That

definition was enacted to ensure uniform reporting byparties in similar economic situations. As business prac-tices have become more complex, substantive law entitiesare used in a manner they were not used in the past. Theiruse often does not change the economic situation. Relyingon substantive law to answer the co-ownership-partnershipquestiondoesnotaddressthemorefundamen-tal economic situation of an arrangement but merely pro-vides liability protection and facilitates financingarrangements. Thus, if tests that distinguish between dif-ferent economic situations control, substantive law entitiesshould be disregarded in answering the co-ownership-partnership question. The appropriate place to disregardsubstantive law entities is the first step of the analysis (thatis, determining whether a separate entity exists) under thecheck-the-box regulations, not section 761(a)(1).



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A HISTORY AND ANALYSIS OF THE CO-OWNERSHIP...

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