Forming a Partnership The following sections contain general information aboutpartnerships. Organizations Classified as Partnerships An unincorporated organization with two or more members isgenerally classified as a partnership for federal tax purposes if itsmembers carry on a trade, business, financial operation, or ventureand divide its profits. However, a joint undertaking merely to shareexpenses is not a partnership. For example, co-ownership of propertymaintained and rented or leased is not a partnership unless theco-owners provide services to the tenants. The rules you must use to determine whether an organization isclassified as a partnership changed for organizations formed after1996. Organizations formed after 1996.An organization formed after 1996 is classified as a partnershipfor federal tax purposes if it has two or more members and it is noneof the following. An organization formed under a federal or state law thatrefers to it as a corporation, body corporate, or body politic. An organization formed under a state law that refers to itas a joint-stock company or joint-stock association. An insurance company. Certain banks. An organization wholly owned by a state or localgovernment. An organization specifically required to be taxed as acorporation by the Internal Revenue Code (for example, certainpublicly traded partnerships). Certain foreign organizations. A tax-exempt organization. A real estate investment trust. An organization classified as a trust under section301.7701-4 of the regulations or otherwise subject to specialtreatment under the Internal Revenue Code. Any other organization that elects to be classified as acorporation by filing Form 8832. For more information, see the instructions for Form 8832. Organizations formed before 1997.An organization formed before 1997 and classified as a partnershipunder the old rules will generally continue to be classified as apartnership as long as the organization has at least two members anddoes not elect to be classified as a corporation by filing Form 8832. Family Partnership Members of a family can be partners. However, family members (orany other person) will be recognized as partners only if one of thefollowing requirements is met. If capital is a material income-producing factor, theyacquired their capital interest in a bona fide transaction (even if bygift or purchase from another family member), actually own thepartnership interest, and actually control the interest. If capital is not a material income-producing factor, theyjoined together in good faith to conduct a business. They agreed thatcontributions of each entitle them to a share in the profits, and somecapital or service has been (or is) provided by each partner. Dusseldorf accommodationCapital is material.Capital is a material income-producing factor if a substantial partof the gross income of the business comes from the use of capital.Capital is ordinarily an income-producing factor if the operation ofthe business requires substantial inventories or investments inplants, machinery, or equipment. Capital is not material.In general, capital is not a material income-producing factor ifthe income of the business consists principally of fees, commissions,or other compensation for personal services performed by members oremployees of the partnership. Capital interest.A capital interest in a partnership is an interest in its assetsthat is distributable to the owner of the interest in either of thefollowing situations. The owner withdraws from the partnership. The partnership liquidates. Chambre VilamouraThe mere right to share in earnings and profits is not a capitalinterest in the partnership. Gift of capital interest.If a family member (or any other person) receives a gift of acapital interest in a partnership in which capital is a materialincome-producing factor, the donee's distributive share of partnershipincome is subject to both of the following restrictions. It must be figured by reducing the partnership income byreasonable compensation for services the donor renders to thepartnership. The donee's distributive share of partnership incomeattributable to donated capital must not be proportionately greaterthan the donor's distributive share attributable to the donor'scapital. Purchase.For purposes of determining a partner's distributive share, aninterest purchased by one family member from another family member isconsidered a gift from the seller. The fair market value of thepurchased interest is considered donated capital. For this purpose,members of a family include only spouses, ancestors, and linealdescendants (or a trust for the primary benefit of those persons). Example.A father sold 50% of his business to his son. The resultingpartnership had a profit of $60,000. Capital is a materialincome-producing factor. The father performed services worth $24,000,which is reasonable compensation, and the son performed no services.The $24,000 must be allocated to the father as compensation. Of theremaining $36,000 of profit due to capital, at least 50%, or $18,000,must be allocated to the father since he owns a 50% capital interest.The son's share of partnership profit cannot be more than $18,000. Husband-wife partnership.If spouses carry on a business together and share in the profitsand losses, they may be partners whether or not they have a formalpartnership agreement. If so, they should report income or loss fromthe business on Form 1065. They should not report theincome on a Schedule C (Form 1040) in the name of one spouse as a soleproprietor. Each spouse should carry his or her share of the partnership incomeor loss from Schedule K-1 (Form 1065) to their joint or separateForm(s) 1040. Each spouse should include his or her respective shareof self-employment income on a separate Schedule SE (Form 1040),Self-Employment Tax. This generally does not increase thetotal tax on the return, but it does give each spouse credit forsocial security earnings on which retirement benefits are based. Partnership Agreement The partnership agreement includes the original agreement and anymodifications. The modifications must be agreed to by all partners oradopted in any other manner provided by the partnership agreement. Theagreement or modifications can be oral or written. Partners can modify the partnership agreement for a particular taxyear after the close of the year but not later than the date forfiling the partnership return for that year. This filing date does notinclude any extension of time. If the partnership agreement or any modification is silent on anymatter, the provisions of local law are treated as part of theagreement.