Tax Situationships: When Two Become One (Whether They Like It or Not)

In the lexicon of modern romance, a “situationship” describes a relationship that refuses definition – two people who drift together, share experiences (and perhaps even more), yet steadfastly avoid labels. It is commitment without commitment, intimacy without intention. The relationship exists in limbo – undefined yet consequential.

American tax law harbours a strikingly similar phenomenon. When two or more persons join together to carry on a business and divide the profits, they may inadvertently create a partnership for US federal income tax purposes. This can be the case regardless of whether they file articles of organisation, sign a partnership agreement or even acknowledge the relationship exists. This transformation occurs by operation of law, often entirely unbeknownst to the participants. Like its romantic counterpart, the tax situationship is defined by ambiguity.

The foundation of every tax situationship lies in Section 761(a), which includes a broad definition of the term “partnership.” Under US tax principles, the term encompasses “a syndicate, group, pool, joint venture or other unincorporated organisation through or by means of which any business, financial operation or venture is carried on.” This language appears to be designed to capture any form of joint economic activity that might otherwise escape entity-level classification. There is no intermediate status, no “friends with benefits” designation in the federal tax lexicon. If two or more parties carry on a business together and are not a corporation, they default to partnership status.

The Treasury Regulations clarify the trigger – a joint venture or contractual arrangement creates a separate taxable entity when participants carry on a trade, business or financial operation and divide the profits. The critical word is “divide.” An agreement merely to share expenses – e.g., two neighbours constructing a drainage ditch to protect their respective properties – does not create a partnership. But the moment profit-sharing enters the equation, the relationship springs to life. The neighbours need only agree to charge a third party for drainage services, and suddenly they are partners under US tax principles.

Importantly, no written agreement is required. A partnership can arise from conduct alone, from the economic reality of how parties behave toward their venture. Two YouTubers who agree over coffee to “collaborate on a channel” and split advertising revenue 50-50 have likely formed a partnership, whether or not they realise it, intended it or ever put pen to paper.

The seminal case governing partnership classification is Commissioner v. Culbertson, [i] decided by the Supreme Court in 1949. The Court established that the primary inquiry is whether the parties “in good faith and acting with a business purpose intend to join together in the present conduct of the enterprise.” This intent test is nuanced and commonly misunderstood. The required intent is not the intent to form a legal partnership or to file Form 1065, US Return of Partnership Income (more on that later). It is simply the intent to jointly conduct an enterprise for profit.

Two parties in a situationship may vehemently deny they are partners. They may even draft a contract stating “this is not a partnership,” their relationship status steadfastly remaining on “single.” Yet if their conduct demonstrates that they are jointly operating a business – e.g., pooling resources, sharing management decisions, dividing profits, sharing in losses, Culbertson dictates that a partnership exists. The subjective belief that one is not in a partnership is irrelevant if one is objectively behaving like a partner.

Tax practitioners and IRS examiners turn to Luna v. Commissioner [ii] for the practical framework. This 1964 Tax Court case established eight factors that courts apply to determine whether a joint venture constitutes a partnership. These factors function like relationship milestones in romantic partnerships, each one signals increasing commitment, though no single factor is determinative.

The Luna factors examine: (1) the agreement and conduct of the parties; (2) each party’s contributions of capital, property or services; (3) control over income and assets; (4) sharing of losses and risk; (5) participation in management decisions; (6) whether business is conducted in joint names; (7) whether partnership returns were filed; and (8) whether separate books and records were maintained.

Critically, several of these factors can weigh against partnership status, yet a partnership can still exist. The absence of a written agreement does not defeat partnership classification. Conducting business under just one person’s name does not defeat it. Even the failure to file partnership returns does not defeat it, though it does compound the compliance problem. Courts have repeatedly found partnerships in cases where parties had only oral agreements, filed no returns for years and actively denied any partnership existed.

Real estate provides the proverbial breeding ground for tax situationships. Properties are expensive, often requiring pooled capital and active management. Real estate is also frequently purchased by people in personal relationships – e.g., friends, siblings, romantic partners – who often trust each other enough to skip the formalities.

The regulations offer a safe harbour – “mere co-ownership of property that is maintained, kept in repair and rented or leased does not constitute a separate entity for federal tax purposes.” This allows siblings who inherit a farmhouse and rent it for passive income to remain simple co-owners, each reporting their share of income and expenses on Schedule E without the complexity of Form 1065. But co-owners should tread carefully as if they are more than merely passive owners (e.g., the actively manage the property), they may not qualify under the safe harbour.

The most painful aspect of a tax situationship often arrives years later, when an IRS audit forces a retroactive definition upon the relationship. Section 6698 imposes strict liability penalties for failure to file Form 1065. For 2026, the penalty is $255 per partner, per month, for up to 12 months per tax year. These penalties can quickly add up for tax situationships that have existed for many years without ever filing a partnership return.

In the case of US persons living outside the US, the IRS may also require a Form 8865, Return of US Persons with Respect to Certain Foreign Partnerships, to be filed with their individual tax return. The information return carries an even heftier penalty of $10,000 per year.

How does one avoid the heartbreak of an accidental partnership? The answer lies in intentionality.

For truly passive arrangements – e.g., investment pools, raw land holdings, etc. – taxpayers can file a Section 761(a) election to be excluded from partnership treatment. This requires filing a blank Form 1065 containing only the election statement in the first year; thereafter, the entity vanishes for tax purposes and members report as co-owners. But this election is unavailable for active businesses.

In the end, the tax situationship offers a cautionary tale about the cost of ambiguity. The IRS does not recognise “it’s complicated” status. There are only compliant ventures and noncompliant ventures. Unlike romantic relationships, where vagueness can be comfortable (or even thrilling), in tax law ambiguity has consequences.

The taxpayers who suffer most are not those engaged in sophisticated tax avoidance, but those engaged in casual collaboration – friends starting a side business, couples buying property together, creators pooling audiences. Their situationships arise from trust, convenience and informality. Yet US tax law, with its binary classifications and often onerous filing requirements, may punish informality.

Perhaps the real lesson this Valentine’s Day is that some relationships demand definition – not because the parties want clarity, but because a third party insists upon it. And when that third party is the IRS, refusing to have “the talk” is not an act of freedom; rather it can be an act of negligence. Better to define the relationship on your own terms than to have it defined for you in an IRS inquiry.

[i] 337 U.S. 733 (1949).

[ii] 42 T.C. 1067 (1964).