SSR 84-11: SECTION 211(d) (42 U.S.C. 411(d)) NET EARNINGS FROM SELF-EMPLOYMENT -- PARTNERSHIP -- HUSBAND AND WIFE
20 CFR 404.1080 and 404.1081
- Under the Social Security Act (the Act) and the Internal Revenue Code (IRC), many businesses that are conducted by husbands and wives may be considered operating as partnerships. Generally, a partnership is created where two or more persons join together for the conduct of a business for profit. Selected cases illustrate factors considered by courts in determining whether a partnership exists.
The Act governs the Social Security coverage of self-employment income while the applicable tax provisions are in the IRC. Following is a discussion of the law and of how it applies in situations where a husband and wife jointly conduct a trade or business.
Section 211(a) of the Act defines "net earnings from self-employment" as the gross income, figured under subtitle A of the IRC, derived by an individual from any trade or business he or she carried on, less applicable deductions allowable under that subtitle, plus the individual's distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member, subject to specified exclusions.
Section 211(d) of the Act provides that the terms "partner" and "partnership" shall have the same meaning as when used in sections 701 through 761 of subchapter K of chapter 1 of the IRC. Section 761 defines the term "partner" as a member of a "partnership." In the case of Commissioner of Internal Revenue v. Tower, 327 U.S. 280 (1946), the Supreme Court said "[A] partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses." 327 U.S. at 286.
In the case of Commissioner of Internal Revenue v. Culbertson, 337 U.S. 733 (1949), the Supreme Court provided the following test for determining whether a partnership is real for income tax purposes:
- ". . . whether, considering all the facts -- the agreement, the conduct of the parties in execution of its provision, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent -- the parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise." 337 U.S. at 742.
Under section 761(a) of the IRC, the term "'partnership' includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not . . . a corporation, trust, or estate." For Federal tax purposes, whether a business entity is a partnership is a matter of Federal, not State, law.
Questions concerning the proper crediting, for Social Security coverage purposes, of income derived from a business operated by a husband and wife are not infrequent. It may be alleged, for example, that even though income from a business was reported by one spouse (usually the husband), both spouses, in fact, ran the business as joint owners and operators and the earnings should be divided between them for coverage purposes. Such questions may arise where one spouse is claiming coverage necessary for entitlement to Social Security benefits or alleges that deductions should not be imposed on benefits on account of work.
While an alleged change in a husband-wife business relationship may be merely a fabrication, it is quite possible that a couple may have actually operated their business as a partnership without recognizing that fact. The question of whether a partnership is real for income tax purposes depends on whether the parties in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise. In many instances, this question can only be answered by a close scrutiny of their actions in carrying on the business. The failure of the spouses to file partnership tax returns does not necessarily mean that a partnership did not exist.
The fact that many small family partnerships do not file partnership tax returns has resulted in Revenue Procedure 81-11. Under the provisions of Revenue Procedure 81-11, the penalty provided for under section 6698 of the IRC for failure to timely file partnership tax returns is not imposed in certain instances involving small partnerships of the type that historically have not filed partnership returns. Revenue Procedure 81-11 does not eliminate the filing requirement for partnerships that historically have not filed; it merely provides that a penalty for failure to file will not be assessed.
Where family partnerships are concerned, many of the customary formalities associated with partnership business operations often do not exist. Because family business arrangements are routinely subject to special scrutiny by both the Social Security Administration and the Internal Revenue Service, many businesses carried on informally by husbands and wives jointly are found to qualify as partnerships.
The following court cases provide guidance on how to recognize the existence of husband and wife partnerships.
Nickerson v. Ribicoff, 206 F.Supp. 232 (D. Mass., 1962)
This was an action for review of a final decision by the Secretary of the Department of Health, Education, and Welfare which denied plaintiff's application for old-age insurance benefits because she did not have the required insured status under the Act. The principal issue before the court concerned the plaintiff's allegation that she was entitled to self-employment income for 2 years resulting from a business partnership with her husband. The wife's participation in the business was substantially the same in years prior to the 2 years for which the partnership was alleged. Additionally, the plaintiff and her husband were aware that by construing the business as a partnership, she could obtain the insured status necessary for entitlement to benefits.
The facts established that the husband conducted an electrical business from his home for over 30 years. In the early years of the business, his wife contributed $1,000 of funds she had received from a relative. She had for many years helped her husband by taking orders for jobs over the telephone, by transmitting supply orders to electrical salesman, and by relaying emergency job messages to her husband when he was at another work site. She assisted him in preparing bills and taking care of the books. They shared a joint bank account with each having the right to sign checks. The business phone, town business certificate, billheads, and advertisement on their truck all showed -- "Nickersons -- Electricians." They agreed that decisions as to purchase, what prices to charge for electrical repairs, whom to hire and how much to pay them, when to borrow money, and what advertising to do would mostly be made by the husband. The wife had no acknowledged skills as an electrician and did not participate in that aspect of the business.
In finding for the plaintiff, the court noted that the denial of a partnership was based on erroneous application of the law to the facts of the case. Thus, the services performed and the capital contribution made by the plaintiff were not necessarily the exclusive tests. Rather, the intent of the spouses in forming the partnership, as demonstrated by all the facts, was controlling. The court found that there was a community of interest in the business profits or losses, that the wife was an important contributor to the success of the business, and that her contributions reflected the intent of the spouses to conduct a bona fide partnership.
The court brought out the following points which should be noted:
- Formation of partnerships solely to enable a partner to qualify under the Act is permissible.
- The lack of evidence of any change in the legal relationship of a claimant for old-age insurance benefits and her husband who worked together operating a business for many years is not controlling as to whether a partnership exists when the business relationship is asserted only near retirement.
- There is nothing to prevent an artisan from being a partner with a non-artisan if the other requisites of a partnership are present. Where there is a community of interest in business profits or losses, where the wife is an important contributor to the success of the business, and where her contributions reflect the intent of the spouses to conduct a bona fide partnership, the existence of a partnership is indicated.
Bratton v. Commissioner of Internal Revenue, 193 F.2d 416 (10 Cir., 1951)
The issue before the court was whether a partnership existed between Mr. Bratton and his wife with respect to their operation of a dairy business.
The facts established that following graduation from college Mr. Bratton was employed in the capacity of supervising retail dairy stores. He was required to do considerable traveling and Mrs. Bratton usually accompanied him on trips and assisted him in his work. Some years later they acquired a going dairy business which, at the former owner's insistence, they operated as a corporation. Both Mr. and Mrs. Bratton were obligated for the $10,000 note which provided the funds for the down payment on the purchase of the business. One hundred shares of common stock were then issued -- 98 to Mr. Bratton, 1 to Mrs. Bratton, and 1 to the lender of the $10,000. Subsequently, a partnership was created among Mr. and Mrs. Bratton and a third party and his wife to operate this business. At that time Mrs. Bratton contributed an additional $1,000 which she had borrowed from the corporation. The partnership, which was created by written agreement in conformity with State law, provided that Mr. and Mrs. Bratton would each have a 5/14 share of the profits and losses of the business, the remainder being shared by the third party and his wife.
While the initial capital investment may have been somewhat clouded by the corporate structure, Mr. Bratton considered his wife an equal in the investment. And the corporate stock later became their major capital contribution to the partnership. Mrs. Bratton was a vital element of the partnership through her participation in the buying and selling of dairy products. From its creation, she was recognized as a partner by all members of the partnership. Through her efforts many of the more profitable business accounts were acquired. She participated in management decisions concerning the business operation. She could write checks on the partnership account and assumed a share in any profits, losses, or liabilities created by the partnership. Disinterested witnesses testified as to her participation in the business and her value to it.
The court considered that the evidence clearly established that a partnership existed. The wife's capital contribution was substantial and her skills and business judgment were substantial factors in the control and management of the business. Further, the risk sharing and mutuality of effort between Mr. and Mrs. Bratton left little doubt as to their intent to join together for a business purpose and create a bona fide partnership.
Parrish v. Halpin, 58-2 USTC para 9812 (S.D. Iowa, 1958)
The issue before the court was whether there was a partnership between plaintiff and his wife. Plaintiff conveyed by bill of sale an undivided one-half interest in the assets of a drugstore business to his wife. However, all assets acquired and profits previously earned were to remain the sole property of the plaintiff. At the same time, they signed a partnership agreement stating that each had contributed one-half of the invested capital of the business and each was to share equally in the management and the net profits of the partnership. In fact, the wife did not pay any money or furnish any other consideration for the transfer to her by the bill of sale of the undivided one-half interest in the business. Further, she rendered no services to the partnership after the date of the bill of sale. Each filed separate income tax returns reporting one-half of the income from the drugstore. The Commissioner of Internal Revenue determined that plaintiff was the taxpayer who earned all of the partnership income.
The court affirmed the Commissioner's ruling. It found that there was no business purpose for the plaintiff to enter into partnership with his wife. The partnership made no real change in the economic situation of the family. The partnership made no real change in the management or control of the business. The wife did not render any services in the business. The plaintiff did not consider his wife the true owner of an undivided one-half interest of the business or that she earned one-half of the income as a result of his transfer to her of a undivided one-half interest in certain assets. The plaintiff's wife did not consider that she owned one-half of the partnership income or that she was the true owner of one-half of the partnership assets.
Ardolina v. Commissioner of Internal Revenue, 186 F.2d 176 (3rd Cir., 1951)
This case involved an appeal from a decision of the Tax Court that no partnership existed between Edward Ardolina and his wife.
When Mr. Ardolina and his wife were married, they were both working, he as a "bench hand" in the jewelry trade and she in a factory. She continued working until she quit to have a baby. Although she never re-entered the labor market, she took in boarders in an effort to supplement the family income.
Some years later, the taxpayer was offered an opportunity to go into business with his employer and two other men. They intended to do business through a corporation and the taxpayer would be required to pay $500 as his share of the capital. His wages had been too small to permit any savings; however, Mrs. Ardolina had managed to save money from taking in boarders and gave him the $500.
The corporation was dissolved a few years later and the business was continued as a partnership between Mr. Ardolina and Mr. Dietz, his former employer. This partnership was dissolved upon the death of Mr. Dietz. A second partnership agreement was entered into between the taxpayer and Mrs. Dietz and her daughter. This arrangement proved unsatisfactory, and Mr. Ardolina bought out the Dietzs' interest. Almost immediately he formed a third partnership with his wife, and it is the validity of this partnership that is at issue.
The agreement was in writing and almost identical with the two previous partnership agreements. It recited that Mrs. Ardolina had purchased a one-half interest in the business, as evidenced by her promissory note. The agreement further provided that Mr. Ardolina was to devote himself to the business and be in direct charge of the operation and management of the ordinary business of the partnership. While Mrs. Ardolina was expected to "use her power and skill for the interest and advantage" of the partnership, she was not expected to devote any time or attendance to the business. After payment of a salary to Mr. Ardolina, any net profit was to be divided equally between them with losses to be borne in equal proportions. All checks on the partnership account required the signature of Mr. Ardolina only.
The promissory note of Mrs. Ardolina was marked "Paid" about 30 days after the agreement was signed. The taxpayer testified it had been paid by money which he gave his wife. Notice of the formation of the new partnership was give to banks, insurance companies, and the State unemployment commission, and a trade name certificate was filed with the county. For the next several years, Mrs. Ardolina was credited with and paid one-half of the company's profits. She testified that she used part of her share to pay her own income taxes, to help relatives, and to take care of personal expenses; she invested the balance. The business was eventually sold, and Mrs. Ardolina received her share of the purchase price.
The Internal Revenue Service held that no partnership existed and the Tax Court agreed. The Tax Court considered that Mrs. Ardolina contributed neither outside capital nor service to the business; that she took no part in the direction or management of the business; that domination over the business by Mr. Ardolina continued unchanged; and that there was no intent on the part of Mr. Ardolina to join with his wife as a partner in the operation of the business.
The Court of Appeals disagreed and reversed. The court noted, citing Commissioner of Internal Revenue v. Culbertson, 337 U.S. 733 (1949), that the facts to be considered in ascertaining whether the parties in good faith and acting with a business purpose intend to join together in the present conduct of an enterprise are the agreement itself, the conduct of the parties in the execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent.
The "agreement" was similar to that of the two previous partnerships of which the taxpayer was a member. All contained a provision charging Mr. Ardolina with the executive management of the company. The business had prospered under this management, and there was no reason to change methods of operation simply because of the replacement of a member of the partnership.
The "conduct of the parties" evidenced an intent to continue to operate the business in a normal manner without change. The court considered the "statements" of the parties vitally contributed to both their good faith and business purpose. The court noted the taxpayer's gratitude to his wife for giving him a start in business. He wanted the business to continue after his death, and he wanted her as a partner so that the company could be continued after his death under her management should be predecease her.
The court noted that there was no "testimony of disinterested parties," but there was forceful, disinterested evidence in the form of the two prior partnership agreements. Both those documents showed that he followed the same company policy with his wife as he had with his former partners.
While the "relationship of the parties" was that of husband and wife, this cannot be dispositive of the issue in view of other facts showing a partnership.
Mr. Ardolina had been the business manager under all agreements; nothing is known abut the abilities of Mr. Dietz. Therefore, a consideration of "respective abilities" must be limited to a comparison of the abilities of Mrs. Ardolina with those of Mrs. Dietz and her daughter. It was a fair inference that Mrs. Ardolina had the greater ability; it was the lack of comprehension of business operations and unreasonable demands upon the business by the Dietz family that caused the dissolution of the second partnership.
Mrs. Ardolina's "capital contribution" was in the form of a gift from her husband. But it must be remembered that it was a gift from her to him that originally enabled him to enter the business. Also, it noted that it was an erroneous assumption that one can never make a gift to a member of the family if the gift is then invested in the family partnership.
The actual "control of income and the purposes for which it was used" by Mrs. Ardolina was the same as that of previous partners. No "other facts" indicated anything other than good faith in entering into the partnership agreement.
The court concluded that it saw no reason why what was obviously a valid partnership under two previous agreements should become invalid under a third. The evidence clearly indicated no change in the business operation was intended under the third partnership. That the new partner was married to the partner continuing the business does not destroy the partnership's validity.