Jeremy Wells

Section 7216: What tax professionals must know before sharing client information

Earmark Team · September 2, 2026 ·

Grady has hit capacity. He runs Lighthouse Accounting LLC, a solo firm that provides tax preparation, planning, representation, bookkeeping, payroll, and some attestation work. To grow, he could hire seasonal preparers, outsource work to a contractor, or merge into a colleague’s firm.

Those staffing and business decisions are also federal compliance questions.

Giving a contractor access to a client portal, forwarding a client email, or sharing a client list with a potential buyer may trigger Sections 7216 and 6713 of the Internal Revenue Code. A knowing or reckless violation of Section 7216 is a misdemeanor punishable by up to one year in prison, prosecution costs, and ordinarily a fine of up to $1,000. The maximum fine rises to $100,000 when the disclosure or use is connected with a crime involving the misappropriation of another person’s taxpayer identity. Section 6713 separately imposes a civil penalty of $250 per unauthorized disclosure or use, capped at $10,000 per calendar year; for identity-theft-related conduct, those amounts rise to $1,000 per disclosure or use and $50,000 per calendar year. Unlike Section 7216, Section 6713 contains no express knowing-or-reckless requirement, and the same conduct can trigger both provisions.

In Episode 35 of Tax in Action, Jeremy Wells, EA, CPA, uses Grady’s choices to explain a practical three-question test:

Is this tax return information?
Is a use or disclosure occurring?
Does an exception allow it without the taxpayer’s consent?

Tax return information goes beyond the completed return

Generally, Section 7216 prohibits a tax return preparer from knowingly or recklessly disclosing or using a taxpayer’s tax return information for a purpose other than preparing the return, unless the Code or regulations authorize the disclosure or use.

For these rules, a tax return includes an original or amended income tax return imposed under Chapter 1 of the Code. That includes Forms 1040, 1120, and 1041. Form 1065 and employment tax returns such as Forms 940 and 941 are not automatically covered because they are not returns of income tax imposed under Chapter 1. Information from those filings may nevertheless become protected tax return information when furnished in connection with preparing a covered income tax return.

The term “tax return preparer” is also broad. It can include people who prepare or assist with returns, their employees, and providers of auxiliary services. Examples may include tax software companies, e-file providers, tax-focused publishers, and professional liability insurers. Creditors, office landlords, and people who provide information at a taxpayer’s request or provide services only incidentally related to return preparation generally are not preparers.

Most importantly, “tax return information” includes information furnished in any form for, or in connection with, preparing a return. It can include:

Names, addresses, and taxpayer identification numbers
Documents supplied by the client
Calculations and recommendations produced by the preparer
IRS acceptance notices and e-file rejections
Statistical compilations, even when anonymized

The client’s reasons for providing the information play a part. A profit and loss statement given to a business coach to improve operations may not be tax return information. The same statement given to a tax professional for return preparation may be protected.

That purpose-based definition leads to the next question: What counts as a use or disclosure?

A disclosure doesn’t require sending a document

A use occurs when a preparer relies on tax return information to take or permit an action. For example, if you identify a client’s IRA eligibility while preparing a return and recommend a contribution, you’ve used the information. Classifying an action as a use does not mean it is prohibited; rather, ask whether the Code, regulations, or valid consent authorize the use.

A disclosure occurs when you make tax return information known to another person in any manner. Examples include:

Emailing a return
Granting access to tax software or a client portal
Sharing a client folder
Forwarding an email containing client information
Allowing someone to see information on your screen

Some disclosures happen without an intentional file transfer, so access itself matters.

Once you identify a use or disclosure, you must determine whether an exception applies.

Employees, contractors, and buyers face different rules

Grady’s seasonal employees generally may access client information without written consent if Grady and the employees are based in the United States and work for the same firm. If Grady is based in the U.S. and hires an employee overseas, however, he needs written consent from each affected taxpayer before providing access. For Form 1040-series taxpayers, Social Security numbers generally must be masked or redacted before a foreign disclosure unless both the U.S. and foreign preparers maintain adequate data protection safeguards and the consent contains the prescribed language.

Donna, an independent bookkeeper, presents a different problem. If Grady brings her in as an outside contractor and gives her access to his portal, she isn’t an officer, employee, or member of his firm. Grady may disclose information without consent under the preparer-to-preparer exception only if Donna qualifies as another tax return preparer located in the United States, including as a qualifying auxiliary-service provider. The disclosure must be necessary for preparing or assisting with a return or providing auxiliary services connected with return preparation, and Donna may not make substantive determinations—an analysis, interpretation, or application of the law—or provide advice affecting the reported tax liability. If those conditions are not satisfied, Grady must obtain valid written consent before giving Donna access to the portal.

He could instead refer the bookkeeping clients directly to Donna. If the clients give their information to Donna themselves, Grady isn’t making the disclosure. But, Grady should not give Donna client names or contact information directly without consent or another applicable exception, because doing so would itself disclose tax return information, and the client-list exception does not authorize solicitation of services other than tax return preparation.

A firm sale has its own exception. The regulations permit certain disclosures without individual consent in connection with the sale or other disposition of a tax return preparation business. Grady may share a list containing client names, addresses, and tax form numbers without individual consent if the potential buyer first signs a confidentiality agreement. That agreement must protect the information and prohibit its use or disclosure for any purpose other than due diligence for the purchase.

Other exceptions cover certain narrow and fact-specific disclosures to software and e-file providers, related taxpayers without a harmful conflict, peer reviewers, courts, regulators, law enforcement, and successor preparers after death or incapacity.

The consent rules are critical when no exception applies.

Consent must come before the disclosure

Taxpayer consent must be written, knowing, voluntary, and received before the use or disclosure. A signature obtained on Tuesday can’t cure a disclosure made on Monday.

Valid consent generally identifies:

The preparer and taxpayer
The purpose and recipient, or the authorized use
The information being disclosed or used
Any applicable disclosure to a preparer outside the United States
The taxpayer’s signature and date

The preparer must give the taxpayer a copy when the consent is signed. One document may authorize multiple uses or multiple disclosures, but not both, and each must be specifically identified. For taxpayers not filing Form 1040-series returns, a consent may use another format, including an engagement letter, provided it satisfies the regulation’s core requirements, and the separate-document rule does not apply. A consent may specify its duration; if it does not, it remains effective for one year from the date of signature.

Generally, conditioning services on the taxpayer’s consent makes the consent invalid. A narrow exception permits a preparer to condition tax return preparation services—or change their terms or cost—when consent is needed to disclose information to another preparer for services connected with preparing the taxpayer’s return.

Apply the same test to every workflow

Section 7216 sets a legal minimum, but it’s not a complete privacy program and is only one part of a firm’s privacy and data security obligations. Jeremy recommends analyzing potential disclosures in the same order every time:

Determine whether the information qualifies as tax return information
Decide whether a use or disclosure is actually occurring
Check the regulations for an exception
If no exception applies, get valid written consent in advance

Apply that test before hiring a seasonal preparer, outsourcing client work, or opening due diligence. Then listen to the full Tax in Action episode for Jeremy’s complete walkthrough of the Lighthouse Accounting case study.

Four ways out of a partnership and the hot assets waiting in each one

Earmark Team · August 27, 2026 ·

Jessica wants out of Lighthouse LLC. After several years of losses, her partner Seth remains committed, but she is done. If Seth pays her $10,000 for her interest, the transaction may look small, but it isn’t.

The transaction also relieves Jessica of her $40,000 share of partnership liabilities. For tax purposes, that debt relief helps produce a $50,000 amount realized. The check alone doesn’t tell the whole story.

In a recent episode of Tax in Action, Jeremy Wells, EA, CPA, closes his four-part partnership series by connecting outside basis, distributions, and dispositions. These topics belong together because outside basis helps determine whether distributions are taxable and how much gain or loss a partner recognizes when leaving.

Outside basis belongs to the partner

Outside basis is a partner’s adjusted tax basis in the partnership interest. It is not the partnership’s basis in its assets, and it is not the partner’s capital account.

A capital account is a separate partnership-level measure of a partner’s equity. It may be negative and generally does not include the partner’s share of liabilities or partner-level basis adjustments.

Jeremy emphasizes individual partners must maintain the record. “Individual partners, not partnerships, are responsible for tracking the partner’s basis in their partnership interest.”

Initial outside basis may come from:

The adjusted basis of property contributed under Section 722
The cost of a purchased partnership interest
Section 1014 basis for an inherited interest
Section 1015 basis for an interest received by gift

Basis then increases for income, gains, additional contributions, and increases in the partner’s share of liabilities. It decreases for distributions, losses, deductions, and reductions in the partner’s liability share.

The order matters, too. Positive adjustments come first, followed by nonliquidating distributions and then losses and deductions. This ordering generally preserves tax-free distribution treatment when possible. You normally calculate basis at year-end, but if the partner disposes of their interest during the year, you calculate it on the disposition date.

That leads to a practical warning. Tax software may produce a basis worksheet, but the worksheet might not appear if you didn’t enter an original basis. If the records are missing, practitioners may need to reconstruct basis using prior K-1s, capital account information, contributions, distributions, and annual liability changes. The partner carries the burden of proving enough basis to deduct losses.

Section 704(d) suspends losses above basis. They can become deductible if income or a contribution later restores basis. For an individual, outside basis is only the first limitation. Sections 465, 469, and 461(l) may also restrict losses. Suspended Section 704(d) losses generally don’t transfer to another taxpayer, so an exit can leave them unused permanently.

Debt relief counts even when no cash changes hands

Partnership liabilities make outside basis especially important. Section 752 treats an increase in a partner’s share of partnership debt like a cash contribution. It treats a decrease like a cash distribution.

The rule reflects the economics. When a transaction relieves a departing partner of debt exposure, that partner receives a financial benefit even if no money changes hands.

Liability allocations don’t automatically follow ownership percentages. You generally allocate recourse debt to the partner or related person who bears the economic risk of loss, such as through a qualifying guarantee or pledged collateral. Nonrecourse debt follows a different, more complex allocation process.

For Jessica, $0 of tax-basis capital plus a $40,000 liability share (assuming no other partner-level basis adjustments) gives her an assumed $40,000 outside basis. You treat her as receiving $40,000 when that liability share falls to zero.

Hot assets can convert capital gain into ordinary income

A sale or exchange of a partnership interest generally produces capital gain or loss under Section 741. Section 751(a) creates an important exception for “hot assets,” including unrealized receivables and appreciated inventory.

Having receivables or inventory on the balance sheet alone does not settle the issue. We must examine whether the partnership has unrealized receivables or appreciated inventory and whether the transaction is a sale, exchange, or disproportionate distribution covered by Section 751.

Without Section 751, a partner can sell an interest priced partly on future ordinary income and report the entire gain as capital. The rule instead treats the portion tied to hot assets as ordinary.

Suppose Seth pays Jessica $10,000. Her amount realized is $50,000 ($10,000 of cash plus $40,000 of debt relief). After subtracting her $40,000 outside basis, she has a preliminary gain of $10,000. If a hypothetical sale of Lighthouse’s hot assets would allocate $6,000 of ordinary income to Jessica, the result is $6,000 of ordinary gain and $4,000 of capital gain.

You might not see that exposure looking at a cash-basis balance sheet. Practitioners need to examine the tax bases and fair market values of the underlying assets.

Four exits follow different paths but similar arithmetic

Jessica has $40,000 of assumed outside basis, $25,000 of suspended Section 704(d) losses, and potential Section 751 income. Jeremy considers four options:

Abandon the interest. Jessica must show both an intent to abandon and an affirmative act. Silence or nonuse isn’t enough. Assuming Section 751(b) does not apply, her $40,000 liability reduction is treated as money received, using up her $40,000 basis. She recognizes no gain or loss and can’t use the $25,000 of suspended losses.
Sell to Seth. The $10,000 payment plus $40,000 of debt relief creates a $50,000 amount realized and a $10,000 preliminary gain. In the example, Section 751 divides it into $6,000 of ordinary gain and $4,000 of capital gain.
Have Lighthouse redeem the interest. This follows the liquidating-distribution rules under Section 736 rather than beginning with Section 741, but the example still produces a $10,000 gain and a similar hot-asset analysis.
Sell to Grady. Jessica’s calculation remains similar. Grady begins with $10,000 of purchase basis and may then receive an allocated share of partnership liabilities. Practitioners shouldn’t assume he automatically receives Jessica’s exact $40,000 share. You have to review guarantees, the operating agreement, and creditor arrangements.

There is also an entity-classification issue. If Jessica leaves without a replacement, Lighthouse becomes a single-member LLC and is disregarded for federal tax purposes by default. If Grady replaces her, Lighthouse remains a partnership.

Plan for the exit before anyone wants out

The practical steps are:

Maintain an outside-basis worksheet with the partner’s return each year
Reconstruct missing basis before claiming losses or completing an exit
Review agreements, guarantees, and collateral before allocating liabilities
Measure suspended losses and consider whether basis can be restored before departure
Test underlying assets for Section 751 ordinary-income potential
Confirm whether the exit changes the LLC’s federal tax classification

As Jeremy explains, abandoning an interest is not a case where “you walk away and nothing happens.” The decisive tax facts often developed years before the exit documents appeared.

Listen to the full Tax in Action episode for Jeremy’s complete walkthrough of the Lighthouse LLC case study.

What Happens When Cash, Real Estate, and Sweat Equity Walk Into an LLC

Earmark Team · August 19, 2026 ·

Three people start a business: Lighthouse LLC, a multi-member LLC treated by default as a partnership. Jessica writes a $500,000 check. Seth hands over real estate valued at $500,000, although his adjusted basis is only $200,000. And Grady rolls up his sleeves and agrees to run the place. They shake hands on one thing: Jessica and Seth should get their money back before Grady sees a dime of profit. It’s clean, it’s fair, and it’s exactly what a lot of investors want.

The catch is that the IRS cares less about the handshake than about whether the numbers behind it tell the truth. In Episode 33 of Tax in Action, host Jeremy Wells, EA, CPA, uses this single fact pattern to walk through the guardrails of Subchapter K.

The operating agreement is only the start of the story. What really governs each partner’s tax treatment is whether the allocations reflect genuine economic substance. Cash distributions and tax allocations are two different things. And Subchapter K’s flexibility survives IRS scrutiny only when it’s anchored by properly maintained capital accounts, built-in gain that stays with the contributing partner under Section 704(c), and special allocations that carry substantial economic effect.

Let’s follow the journey to see how income passes through before cash ever moves, why some items keep their character, how contributed property drags its history along, and what makes a distribution waterfall hold up.

Income flows through before the cash ever does

Start with the most basic rule in partnership tax. Under Section 701 of Subchapter K, a partnership generally pays no federal income tax. Instead, partners include their distributive shares of the partnership’s income, gains, losses, deductions, and credits on their own returns. The kicker is, they do this whether or not the partnership distributes any cash or property.

That’s the foundational disconnect. Getting taxed and getting paid are not the same event.

Jeremy illustrates the point with United States v. Basye (410 U.S. 441, 1973). A group of physicians in a limited partnership called Permanente contracted with Kaiser Foundation Health Plan to provide medical services. Kaiser paid them two ways:

A direct amount tied to the number of members enrolled in the plan
Contributions into a retirement trust funded solely by Kaiser

Permanente never reported the trust contributions as income. The doctors argued they never touched or controlled those funds, and some who left early never collected them at all. As cash-basis taxpayers, they said, they shouldn’t have to report the income.

The district and appellate courts agreed with the physicians, but the Supreme Court reversed, relying on two principles: income is taxable to the party that earned it (the assignment-of-income doctrine, drawn from cases like Lucas v. Earl), and each partner must include a distributive share of the partnership’s income. Together, that made the trust payments taxable to each partner, even the ones who later lost their benefits by breaking their contracts. It can feel harsh, but that’s why you have to warn your clients that a profitable partnership creates taxable income even in a lean cash year.

Income passes through by character as well as by amount. So you can’t dump all of it into ordinary business income.

Separately stated items keep their character

Under Section 702, certain items must be separated from ordinary partnership income and reported separately because they’re taxed differently at the partner level. That category includes:

Qualified dividends
Capital gains and losses
Charitable contributions (which are AGI-limited itemized deductions on Schedule A)
Foreign taxes, which may support a foreign tax credit
Gains and losses on Section 1231 property

The character of each item survives the pass-through as if the partner had realized it directly. Ordinary business income, by contrast, gets blended into a single figure.

Interest isn’t one of the items specifically named in §702(a)(1)–(6), but it nevertheless must generally be separately stated. Jeremy sees it misreported all the time, buried as “other income” on line 7, page one of the 1065. That’s wrong. Interest income belongs on Schedule K, line 5, so it flows correctly to Schedule B of the 1040 and feeds calculations like the net investment income tax on Form 8960.

He also draws the partner-level versus partnership-level line. Passive-loss limitations under Section 469 are tested at the partner level. But profit motive is tested at the partnership level. In Simon v. Commissioner (Third Circuit, 1987), the court held that profit motive turns on the intent of the people managing the partnership, not the investment intent of any single partner. If the folks actually running the business don’t treat it like a business, the partnership may lose its Section 162 deductions.

There’s a related trap. A partner generally can’t deduct partnership expenses on a personal return. The exception is narrow. The partnership agreement or an established practice must require the partner to bear the cost without reimbursement. A partner who simply chooses not to request reimbursement is not entitled to a deduction. Jeremy recommends having the partnership pay its own bills.

These rules protect character. But the heart of the matter is tracking the economics, starting with property that shows up carrying baggage.

Contributed property drags its history along

Under Section 721, contributing appreciated or depreciated property doesn’t trigger immediate gain or loss. Built-in gains and losses are preserved. Section 723 then gives the partnership a carryover inside basis, while the asset is booked at fair market value.

Jeremy uses a second example to show why you have to track two numbers. Jessica contributes $100,000 in cash. Seth contributes real property (FMV $80,000, basis $20,000) plus equipment (FMV $20,000, basis $60,000). That’s $100,000 of value in all, making them 50/50 partners. Book value drives each partner’s interest. Adjusted basis drives depreciation.

Section 704(c) requires pre-contribution built-in gain or loss stay with the contributing partner. Watch the distortion. On the real property, book depreciation of $8,000 gives each 50/50 partner $4,000. But tax depreciation, built on the $20,000 carryover basis, produces only $2,000. Jessica gets that $2,000. The missing $2,000 is the ceiling rule at work. It caps the tax items on 704(c) property at what the property actually generates.

Regulation 1.704-3 offers three fixes:

The traditional method
The traditional method with curative allocations
The remedial method

Each handles the ceiling-rule distortion a little differently, and each gets complicated fast.

To police whether allocations honor the deal, the capital account acts as a scorecard.

Capital accounts and substantial economic effect

A capital account is the book-value measure of a partner’s equity. In other words, it’s what a partner would receive if the partnership liquidated at book value after paying off its liabilities. Contributions and income increase it while losses, deductions, and distributions decrease it. Liabilities don’t affect it, and it’s a separate concept from outside basis. Unlike basis, a capital account can go negative; whether the partner is actually required to restore that deficit depends on the partnership agreement and, in particular, whether the partner has a DRO.

Section 704(b) is where flexibility meets accountability. Legitimate structures are everywhere. An investor gets a return of capital and a preferred return before a service partner shares in residual profits. Abusive ones, such as shifting income to a lower-bracket partner who loops the cash back, or dumping income onto a partner just to soak up net operating loss carryovers, don’t fly.

For the principal safe harbor, an allocation needs economic effect. Under the basic safe harbor, the agreement generally must maintain §704(b) capital accounts, liquidate based on positive capital balances, and require partners to restore capital-account deficits. However, an alternative test can apply without a full DRO if the agreement includes a qualified income offset and meets the regulation’s other limitations. It also has to be substantial, meaning it meaningfully changes the dollars partners receive apart from any tax effects. The difference between the two cures matters. Under a DRO, the partner contributes cash to erase a deficit; under a QIO, income is reallocated to repair it. Keep in mind that missing the safe harbor doesn’t automatically kill an allocation. It just invites more scrutiny. Now bring the tools back to Jessica, Seth, and Grady.

Making the waterfall hold up

A compliant Lighthouse waterfall might send available cash first to Jessica until she recovers her $500,000, then to Seth until he recovers the agreed book value of his property, with remaining profits and distributions shared with Grady after that.

But cash distributions and tax allocations are not the same thing. If Jessica takes the early cash, the agreement must also allocate enough book income to her to support that result. Otherwise the capital accounts distort. And Seth’s roughly $300,000 built-in gain on the appreciated real estate stays with Seth under Section 704(c). It can’t shift to Jessica or Grady just because the property entered the partnership.

Where the money meets the math

Jeremy’s walkthrough boils down to a few lessons worth taping to your monitor:

Partnerships allocate by the agreement, not ownership percentages. Get the operating or partnership agreement before you touch the return. Don’t prepare one without the governing documents.
Separately stated items keep their character. Plan for their partner-level effects; don’t assume everything blends together at the entity level.
Contributed property carries over its tax basis. Watch for 704(c) allocations whenever book and tax values diverge, especially on depreciable or appreciated assets.
Special allocations survive only with substantial economic effect. Genuine economics, not tax gymnastics.

The bigger discipline is simple to state and hard to fake. Honor the deal the partners actually struck by making the tax mechanics mirror the real economic arrangement so the waterfall holds up when the money flows.

For Jeremy’s complete walkthrough of Lighthouse LLC, listen to the full episode of Tax in Action. And stay tuned for the next episode, where he takes on outside basis, distributions, and what happens when a partnership liquidates.

The Four Words Congress Never Defined That Could Cost Your Clients Thousands in Self-Employment Tax

Earmark Team · July 22, 2026 ·

Congress once wrote four words into the tax code: “limited partner as such.” But then it never explained what those words meant. Even worse, they wrote these words before limited liability companies existed. Today, those four words are at the center of a legal battle moving through multiple appellate courts, and the outcome will determine whether your partnership clients owe self-employment tax on their share of income.

In Episode 32 of the Tax in Action podcast, host Jeremy Wells, EA, CPA, picks up where his previous episode on partnerships left off. He tackles two critical questions: What actually makes someone a partner under federal tax law? And which partners must pay self-employment tax on their distributive share?

The answers turn on substance rather than paperwork, and that’s where things get complicated. Since Congress never defined “limited partner as such,” and since the phrase predates LLCs entirely, the courts have split into openly conflicting camps. One camp reads it as a test of whether someone is truly a passive investor. Another looks at state-law definitions and dual-role partners. This is a genuine circuit split that could land at the Supreme Court.

Until it’s resolved, Jeremy makes clear you can’t rely on the “limited partner” label in a K-1 or operating agreement. You have to evaluate what each partner actually does. Let’s walk through how courts define who counts as a partner, why the “limited partner as such” exception is so unclear, and how this circuit split affects your clients right now.

Who Actually Counts as a Partner?

Before we can figure out who owes self-employment tax, we need to answer a more basic question: who counts as a partner in the first place? The answer has always been rooted in substance over form, and that principle causes today’s self-employment tax disputes.

Jeremy opens with a scenario you’ve likely seen. Two individuals register an LLC, each listed as a member. Under the check-the-box regulations, that’s a partnership for federal tax purposes. One member works full time in the business, keeping it running. The other contributed startup capital, works elsewhere, and rarely touches the business. They’re a classic silent partner. With equal 50% interests, the Form 1065 and K-1s report a 50/50 income split.

But are these two partners truly equal under federal tax law? One earns income through labor, while the other just wrote a check. Should the tax code treat them the same?

When the Code Said Nothing

Before 1951, the Internal Revenue Code had no definition of “partner.” This silence created disputes that reached the Supreme Court. With no statute to guide them, the courts had to define it themselves and made a decision that still shapes practice today. They largely ignored state-law labels.

“Partner” can mean one thing under state law and something different under federal tax law. The courts focused on the parties’ stated and implied intent, examining partnership agreements, contributions of capital or services, and how they actually behaved once the business was running.

Tower Sets the Standard

The first landmark case was Tower v. Commissioner (1946). The Court asked whether the individuals truly intended to join together to carry on a business and share in profits and losses. The answer, they said, depends on multiple factors, none of them individually decisive. There’s no simple checklist that automatically makes someone a partner.

The Court said an individual may be a partner if she “either invests capital originating with her or substantially contributes to the control and management of the business, or otherwise performs vital additional services, or does all of these things.”

The backstory drives the point home. Mr. Tower, following tax advice, converted his corporation to a partnership and made his wife a partner purely to shift income to her lower tax bracket. But Mrs. Tower contributed no capital, provided no services, and exercised no control. The Court saw through it and taxed the income to Mr. Tower, who actually earned it.

Culbertson Clarifies the Mess

Three years later was Culbertson v. Commissioner (1949). The Tax Court had misread Tower, treating its list of factors as rigid requirements and denying partnership status left and right. The Supreme Court pushed back, saying the Tax Court “ignores what we said is the ultimate question for decision and makes decisive what we described as circumstances to be taken into consideration.”

The real test is subjective intent: whether the parties, in good faith and with a business purpose, intended to join together in the present conduct of the enterprise.

Congress Steps In for Family Partnerships

In 1951, Congress finally added a statutory definition, now in Section 761(b). A person is recognized as a partner if they own a capital interest in a partnership where capital is a material income-producing factor, whether acquired by purchase or gift.

Congress targeted family partnerships, in which high-earning patriarchs would gift interests to lower-earning relatives to spread income into lower tax brackets while retaining control. According to the Joint Committee’s Blue Book, Congress wasn’t overriding Tower and Culbertson; it was carving out a legitimate transaction, making clear the IRS couldn’t deny partner status just because an interest came from a family member.

The Capital Interest Test

Everything circles back to the concept of capital interest, or an interest in partnership assets that would be distributable upon withdrawal or liquidation. It’s different from a mere profits interest because just sharing in earnings doesn’t cut it.

Courts apply a hypothetical liquidation test. If the partnership shut down tomorrow and sold everything, would this person get a slice of the assets? If not, are they really a partner?

The pattern of economic reality, not paperwork, determines who is a partner. And this same substance-over-form logic becomes far more contentious when we turn to self-employment tax.

The Four Words Nobody Can Define

Now we reach the phrase causing all the trouble, where ambiguity stops being academic and starts costing real money.

First, Jeremy lays down the foundational rules. Partners are treated as self-employed for tax purposes, regardless of their role. This means partners cannot be employees of their own partnership. “You should never have a partner getting both a W-2 and a K-1 from the same partnership,” Jeremy emphasizes. While there are “exceedingly rare” exceptions, the rule holds: partners don’t go on payroll. If a partner wants a fixed income for services, it flows through as guaranteed payments, not wages.

The general partner rule is unforgiving. A general partner’s distributive share is subject to self-employment tax. It doesn’t matter if the interest is passive under Section 469. It doesn’t even matter if the partnership elected out of Subchapter K under Section 761(a). As Jeremy notes, that election only affects Subchapter K. It does nothing to shield general partners from self-employment tax.

The Exception and Its Giant Hole

IRC Section 1402(a)(13) creates an escape hatch by excluding “limited partners, as such” from self-employment tax on their distributive share. But even for limited partners, guaranteed payments for services are subject to self-employment tax.

The problem is Congress never defined “limited partner as such” anywhere.

In 1997, the Treasury proposed regulations to define the term for Section 1402 purposes. The controversy was so intense that Congress imposed a moratorium on any such regulation, and that moratorium was originally set to expire on July 1, 1998. “It’s now 28 years later, and neither Congress nor the Treasury has provided any sort of update on this question,” Jeremy says.

The LLC Problem

Making everything worse, Section 1402(a)(13) was written before LLCs existed. LLC members aren’t personally liable for entity debts. That’s the whole point of limited liability, making them look like limited partners. Yet those same members often actively manage the business and provide services, making them look like general partners.

So which are they for self-employment tax purposes? The statute offers no answer. Congress wrote a rule for a world of general and limited partnerships and never updated it for the entity that now dominates small business.

Courts Split on What “Limited Partner” Means

With no definition and no regulation, the courts filled the vacuum, and they didn’t all fill it the same way.

The Tax Court’s Passive Investor Test

The first approach comes from Renkemeyer, Campbell & Weaver v. Commissioner (2011), involving a law firm. The Tax Court examined the legislative history and concluded Congress intended to “ensure mere passive investors would not receive credits toward Social Security coverage.”

On this reading, “limited partner as such” means “passive investor.” The phrase “as such” signals the exemption applies to those who operate as limited partners. Once a partner participates in operations, they’re no longer a limited partner for federal tax purposes.

The Tax Court expanded this in Soroban Capital Partners (2023), applying its “functional analysis” test. The inquiry is, does the partner functionally participate or stay out? Notably, Soroban involved a state-law limited partnership, yet the court still held that a partner labeled “limited” who acts like a general partner owes self-employment tax. Soroban is currently on appeal in the Second Circuit.

The Fifth Circuit’s State-Law Approach

The competing view comes from Sirius Solutions LLP v. Commissioner. The Fifth Circuit, which Jeremy notes “tends to be different from a lot of the other appellate courts,” rejected the passive-investor approach entirely.

Instead, the court looked at how “limited partner” was defined in legal dictionaries and by the IRS and Social Security Administration when Section 1402 was written. The court’s logic ran three ways.

First, the guaranteed-payments carve-out shows Congress expected limited partners to provide services. As the court said, “the text of the exception itself contemplates that limited partners would provide actual services to the partnership.”

Second, Congress used “passive” terminology elsewhere in the code but not in Section 1402. It used “rendered no services” in Section 1402(a)(10) just a few paragraphs above, yet chose different language in (a)(13). Why different wording for the same concept?

Third, “as such” refers to dual-status partners, or people who act as general partners sometimes and as limited partners at others, clarifying that only their limited-partner income escapes tax.

A Geographic Lottery

These approaches directly conflict. When appellate courts interpret the same federal statute in opposite ways, the natural endpoint is the Supreme Court.

Meanwhile, Jeremy flags a practical complication from the Golsen rule. The Tax Court must follow the precedent of whichever appellate circuit would hear a given case. So a partnership in the Fifth Circuit gets one result while an identical partnership elsewhere gets another. The outcomes are driven purely by geography.

The Jurisdiction Question

Jeremy also discusses Denham Capital Management, on which the First Circuit heard oral arguments in early 2024. Rather than debate what “limited partner” means, the partners argue the Tax Court lacks jurisdiction to decide this in a partnership-level audit. Under TEFRA, net earnings from self-employment are a partner-level item, since individual partners calculate their own self-employment tax.

The wrinkle is partnerships must report self-employment earnings in Box 14 of the K-1. The IRS argues that the “characterization” of income makes it a partnership item. This could add another layer to an already complex issue.

What This Means for Your Practice

Let’s return to Jeremy’s opening scenario. The member working full time is almost certainly a partner whose income is subject to self-employment tax. The capital-only member likely holds a valid partnership interest too. But under the Tax Court’s current precedent, their income probably escapes self-employment tax if they genuinely stay out of the business.

That last part is crucial. Jeremy cites Howell v. Commissioner (2012), where a married couple treated the wife’s LLC earnings as exempt from self-employment tax. But her testimony revealed she occasionally provided managerial and marketing advice to her husband. That occasional participation was enough. The Tax Court held she wasn’t a “limited partner as such,” and her earnings were subject to self-employment tax.

Key Takeaways for Tax Professionals

Jeremy leaves us with clear lessons from this uncertainty:

Federal tax law determines partner status based on economic reality, not state-law labels. That’s the through-line from Tower and Culbertson.
The IRS and Tax Court currently apply a functional analysis to determine if a partner is “limited” for self-employment tax purposes. But recent developments cast doubt on this approach.
Look beyond the paperwork. The words “limited partner” on a K-1 or operating agreement won’t protect a client who functions like a general partner.
Never combine a W-2 and a K-1 from the same partnership. Partners are self-employed; fixed compensation comes through guaranteed payments.
Remember what’s always taxable. General partners’ distributive shares are subject to self-employment tax even if passive or if the partnership elected out of Subchapter K. Guaranteed payments to any partner for services remain subject to SE tax.
Document everything. Track each partner’s participation, services, and management role. As Howell shows, even occasional input can trigger self-employment tax.

Until the Supreme Court resolves this circuit split, you’re advising clients under real uncertainty. The prudent response isn’t to guess which approach will win. Build positions based on what every court agrees matters, which is what each partner actually does.

For Jeremy’s complete analysis of the cases, statutory history, and practical implications, plus previews of upcoming episodes on capital accounts and special allocations, listen to episode 32 of Tax in Action.

Shared Business Activity—not Mere Co-Ownership—Often Determines Partnership Status

Earmark Team · July 20, 2026 ·

Two friends buy a short-term rental together. They split everything, from income and expenses to responsibilities, 50/50. One manages the bookings while the other handles repairs. They never wrote up any agreement, registered an LLC, or created any paperwork at all.

Did these friends accidentally create a partnership with federal filing requirements?

Now make it more complicated. What if those two friends are married? What if they’re flipping houses instead of renting them? What if one spouse does all the work while the other occasionally helps with administrative tasks?

These are real questions that come across the desk of tax professionals every week. While they might seem straightforward, the answers are anything but simple or academic Partnership status affects filing requirements, basis calculations, elections, self-employment tax, audit procedures under the BBA, and the availability of numerous Subchapter K provisions. That’s why correctly identifying whether a partnership exists is the first step in any partnership analysis.

In episode 31 of Tax in Action, Jeremy Wells, EA, CPA, tackles this tough question in small business taxation: When does co-ownership cross the line into a partnership under federal tax law? Drawing from IRC §761(a) and §7701, Treasury regulations, and Supreme Court cases dating back to the 1940s, Jeremy builds a practical framework you can apply to client situations starting today.

Determining whether a co-owned activity is a partnership requires more than checking if someone filed an LLC with the state. You need to analyze the shared profit motive, business activity, and genuine intent. The analysis is shaped by decades of court-tested criteria. You also need to understand the distinct exceptions available to married couples.

Get this analysis right, and you’ll meet reporting requirements while positioning clients for partnership planning opportunities. Get it wrong, and you face unfiled return penalties, missed planning strategies, or both.

The Federal Definition Casts a Wide Net (With Important Limits)

To determine if your client’s co-owned activity is a partnership, you first need to understand how broadly federal tax law defines the term and where it draws the line.

IRC §761(a) defines “partnership” to include syndicates, groups, pools, joint ventures, and other unincorporated organizations (excluding corporations, trusts, and estates). That’s remarkably broad. As Jeremy explains, essentially any business-like activity with more than one participant could qualify. Add the companion definition in IRC §7701(a)(2) and Treasury regulations, and you have a framework that captures far more arrangements than most people realize.

There’s also the familiar default rule: Under Reg. §301.7701-3(b), a domestic eligible entity with two or more members that hasn’t filed a corporate election is treated as a partnership. This is where we get “multi-member LLC equals partnership.” For foreign entities, you need to check whether any member lacks limited liability, but the domestic rule is straightforward.

Despite this broad sweep, the regulations carve out two important exceptions that do not create a separate entity for federal tax purposes:

A joint undertaking merely to share expenses
Mere co-ownership of property (even income-producing property)

That second exception matters most in everyday practice. Two unrelated people can buy a rental property together, split the income and expenses, and that alone doesn’t necessarily create a partnership.

Jeremy shares an example from Laura and Noel Cunningham’s textbook, The Logic of Subchapter K. Two people co-own a taxi cab. Each drives it 12 hours a day, tracking their own fares and expenses separately. No partnership exists because there’s no joint profit motive. What you earn during your shift has nothing to do with what I earn during mine.

But change the facts and lease that cab to a third party who pays both owners. Now you’ve introduced a collective profit motive, and it looks like a partnership.

The Cunninghams identify two key features: business activity and sharing of profit. When both exist, you likely have a partnership. When either is missing, you probably have mere co-ownership.

This is where things get tricky. A single rental property split between two friends is probably mere co-ownership. But if they offer concierge services for an extra fee or they’re building a portfolio of rentals and managing them like a business, each additional fact pushes the activity toward partnership territory.

As Jeremy emphasizes repeatedly, federal tax law, not state law, controls this determination. You can register an LLC, file articles and get a certificate of formation, but none of these facts, standing alone,

determines whether a partnership exists for federal tax purposes. As the Supreme Court established 75 years ago, states can create entities on their books, but they can’t dictate federal tax consequences.

When Partnerships Actually Form

Knowing a partnership can exist is one thing. Knowing when it forms and triggers filing obligations is another matter entirely. It has nothing to do with filing paperwork at the Secretary of State’s office.

A partnership forms for federal tax purposes when participants join capital or services together with the intent to conduct an enterprise or business. Courts generally look for both genuine intent to carry on a business together and some actual contribution of capital or services.

Plans, discussions, and handshake agreements don’t count. Something tangible must go into the pot.

This framework comes from two landmark Supreme Court decisions every practitioner should know.

Tower v. Commissioner (1946) laid the foundation. The Supreme Court held that a partnership forms when people join “their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business” with a “community of interest in the profits and losses.” The critical question: whether the partners “really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses.”

Tower also drew a bright line between state and federal authority. As the Court stated, a state “cannot, by its decisions and laws governing questions over which it has final say, also decide issues of federal tax law.”

Culbertson v. Commissioner (1949) clarified what Tower meant. Lower courts misread Tower as requiring some minimum threshold of capital or services. The Supreme Court corrected this, saying, “The question is not whether the services or capital contributed by a partner are of sufficient importance to meet some objective standard,” but whether “considering all the facts, the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.”

Culbertson produced the factors courts use to assess intent, and practitioners should memorize these criteria:

The agreement and the parties’ conduct in executing it
Whether each participant genuinely participates or is just a name on paper
Testimony of disinterested persons (would vendors or advisors see this as a partnership?)
The relationship of the parties
Their abilities and capital contributions
Actual control of income and how it’s used
Any other facts showing true intent

Jeremy notes that family partnership cases of the 1940s-1960s drove much of this development. Families were forming partnerships primarily for tax benefits. Courts had to determine whether these were genuine business partnerships or just tax avoidance vehicles. When the intent was purely to dodge taxes rather than to operate an enterprise, courts rejected partnership status.

Sparks v. Commissioner (1986) adds practical guidance. The Tax Court held that startup discussions, soliciting contributions, negotiating with third parties, and even incurring expenses were “pre-operating activities,” not partnership formation. The partnership didn’t form until members’ capital interests vested, meaning contributions were made and ownership interests received.

The practical takeaway is to document everything. Jeremy emphasizes that small business owners are terrible at this, and tax advisors must encourage better practices. A partnership or operating agreement that records when contributions were made and the ownership interests received establishes the formation date, not the LLC filing, planning meeting, or domain registration.

Three Ways to Avoid Partnership Treatment

Once you’ve determined a partnership exists, the next question is whether an exception allows the parties to sidestep partnership reporting. Three pathways exist, and practitioners regularly confuse them.

Electing Out of Subchapter K

Under IRC §761(a), members of an unincorporated organization can elect out of Subchapter K treatment if they can determine their incomes individually and the activity involves:

Investment purposes only
Production, extraction, or use (but not sale) of joint property
Securities underwriting over a short period

But the catch is that this election only removes Subchapter K rules. It doesn’t exempt the activity from any other IRC provision.

Jeremy highlights Cokes v. Commissioner (1988) as the cautionary tale. A widow inherited her husband’s interest in an oil venture that had elected out of Subchapter K. She never attended meetings, voted, drilled wells, or supervised operations. Her involvement was zero beyond holding an interest. Still, the Tax Court held her income was from a trade or business, subject to self-employment tax under IRC §§1401 and 1402. The partnership remained a partnership, just not subject to Subchapter K.

Qualified Joint Venture for Married Couples

The first spousal exception is available only to couples filing jointly who meet all three requirements:

The spouses are the only members
Both materially participate under IRC §469(h)
Each reports their share as if operating as a sole proprietor (separate Schedules C (or F) and separate Schedules SE)

This splits what would be a partnership into two sole proprietorships for reporting, eliminating Form 1065.

A critical limitation to be aware of is the qualified joint venture is NOT available if spouses operate through an LLC. If they registered an LLC, this door is closed.

There’s no form to file. Spouses simply submit separate schedules with their joint return. The election continues while requirements are met. Revocation needs IRS permission.

Community Property LLCs

The second spousal exception applies when there IS an LLC, exactly where the qualified joint venture fails. But it only works in nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

To be eligible, the LLC must be wholly owned by spouses as community property with no corporate election filed. When met, Rev. Proc. 2002-69 lets spouses report the activity as either a partnership or a disregarded entity.

This isn’t an election, so there’s no form, statement, or revocation. It’s simply a choice the IRS respects. Spouses can theoretically change annually (though Jeremy says they probably shouldn’t).

Your Two-Step Framework for Partnership Determination

Jeremy distills everything into a practical framework you can apply immediately.

Step 1: Does a partnership exist?

Ask these questions in order:

Are there two or more distinct owners? (Not an individual and their disregarded entity. They have to be two separate taxpayers)
Are they merely co-owning property, or operating a business together?
Is there a shared profit motive? Do they act like business co-owners or like investors holding the same asset?

The more parties look like business owners running an enterprise together, the more likely a partnership exists.

Step 2: Does an exception apply?

Check for:

§761(a) election out of Subchapter K
Qualified Joint Venture under §761(f) (spouses, joint return, no LLC)
Community Property LLC under Rev. Proc. 2002-69 (spouses, community property state, LLC)

Key Takeaways for Tax Professionals

Shared property doesn’t create a partnership. Shared business activity does. One rental is probably co-ownership. A portfolio with services looks different.
State entity formation doesn’t control federal partnership status. The Supreme Court settled this in 1946.
Partnerships form when participants contribute capital or services in exchange for ownership interests, not when they form an LLC or buy a domain. Document that moment.
Push clients toward written agreements. Small business owners resist this. Partnership or operating agreements that record contributions and formation dates are essential.
Don’t confuse the spousal exceptions. Qualified joint ventures and community property LLC rules are completely separate regimes for different situations.
Electing out of Subchapter K doesn’t avoid self-employment tax or any other IRC provision.

These determinations have real consequences. Get it right, and you’ve met reporting requirements while positioning clients for planning opportunities. Get it wrong, and you face unfiled returns, unexpected self-employment tax, or missed savings.

If you’re ready to dive deeper, listen to the full episode of Tax in Action for all the case law details, regulatory citations, and Jeremy’s complete analytical framework. In the next episode, Jeremy examines who qualifies as a partner and tackles the increasingly important question of which partners face self-employment tax.