Brooklyn Law School BrooklynWorks Faculty Scholarship Spring 2011 The Allure and Illusion of Partners' Interests in a Partnership Bradley T. Borden Brooklyn Law School, [email protected] Follow this and additional works at:https://brooklynworks.brooklaw.edu/faculty Part of theTax Law Commons Recommended Citation 79 U. Cin. L. Rev. 1077 (2010-2010) This Article is brought to you for free and open access by BrooklynWorks. It has been accepted for inclusion in Faculty Scholarship by an authorized administrator of BrooklynWorks. THE ALLURE AND ILLUSION OF PARTNERS' INTERESTS IN A PARTNERSHIP Bradley T Borden* Favorable tax treatment and management flexibility make tax partnershipsv ery popular. For starters, tax partnerships, unlike tax corporations,a re not subject to entity-level taxes. Partnershipt axable income flows through to the partners, and the partners report their shares of partnershipt axable income on their individual tax returns. Partnership tax allocation rules determine the partners' shares of partnership taxable income. Those rules rely upon the alluring concept of partners' interests in a partnership. It seems intuitive that partners would know their interests in a partnership and be able to allocate partnership taxable income accordingly. This Article illustrates, however, that the concept is illusory and that it undermines the tax allocation rules, crippling the effectiveness of partnership taxation. Some partners therefore allocate partnership income to reduce their overall tax liability and unfairly deplete government revenue. The Article attributes the concept's allure and illusion to path dependency and tax myopia-partnership tax experts expend considerable effort mastering dfficult rules, which they cling to, and they focus narrowly on the tax aspects of those rules. The Article introduces three correlatives to end the myopia and improve the tax allocation rules: (1) economic items and tax items; (2) state law and tax law; and (3) economic interests and partners' interests in a partnership. The Article illustrates that aspects of the current rules are tax-centric (i.e., economic results follow tax allocations) and * Professor of Law, Brooklyn Law School, Brooklyn, New York. LL.M. and J.D., University of Florida, Fredric G. Levin College of Law; M.B.A. and B.B.A., Idaho State University. The author would like to thank Dana Brakman Reiser, Steven Dean, Heather Field, Marsha Garrison, Tom Henning, Jeff Jackson, Ted Janger, Rebecca Kysar, Leandra Lederman, Andrea Monroe, Glenn Morris, Chris Pietruszkiewicz, Arthur Pinto, David, Reiss, Bill Rich, Mike Schwartz, Chris Serkin, and the participants at faculty workshops at Brooklyn Law School and Louisiana State University Law Center for their helpful comments on earlier drafts and ideas of this Article. The author would also like to thank Samantha Borden and Bobbi Bullock for help preparing drafts of this Article as well as the Brooklyn Law School for generously supporting this work through the Dean's Summer Research Grant. The author retains full responsibility for the opinions expressed herein and any errors that may exist. 1077 1078 UNIVERSITY OF CINCINNATILAWREVIEW [Vol.79 illusory. The rules' tax-centricity may create unintended legal consequences for unsuspecting partners; their illusion creates opportunities for tax abuse. After illustrating the current rules' shortcomings, the Article recommends fundamental reform of the partnership tax allocation rules. It recommends a move to item- specific economic-centric rules that will eliminate the unintended legal and economic consequences of the current rules and curb tax abuse. Introduction ........................................... 1078 I. Correlative One: Economic Items and Tax Items............1084 A. Economic and Tax Items of a Typical Tax Partnership......1085 B. Economic Significance of Tax-Item Allocations................1088 II. Correlative Two: State Law and Tax Law ........... ..... 1092 A. Allocating Economic Items under State Law .... ..... 1092 B. Allocating Tax Items under Tax Law ....... ........ 1098 III. Correlative Three: Economic Interests and Partners' Interests.... 1103 A. Partners' Economic Interests in a Partnership .... ..... 1103 B. Partners' Interests in a Partnership........... ..... 1105 C. Partners' Interests' Inability to Guide Tax-Item Allocations ........................... .... 1112 1. Partnership with Minimalist Partnership Agreement.. ............................. 1112 2. Partnership with Uniform Economic-Item Allocations ................... ....... 1116 3. Partnership with Specially-Allocated Economic Items..................1.7........1117 4. Partnership with Allocated Tax Items..... ....1120 5. Partnership with Target Allocations... ....... 1123 IV. Proposal: Fundamentally Reform Partnership Tax Allocation Rules ................................ ..... 1127 A. Abandon Tax-Centric Allocation Rules ............. 1130 B. Abandon the Concept of Partners' Interests in a Partnership ............................ ... 1132 C. Adopt Item-Specific Economic-Centric Allocation Rules.. 1133 Conclusion ....................................... 1137 INTRODUCTION Tax partnerships are no longer the sole province of ma-and-pa shops and other small businesses. Now, the largest multinational corporations, 2011] PARTNERS' INTERESTS IN A PARTNERSHIP 1079 other businesses, and property owners use them for various reasons.' In fact, tax partnerships hold one-fifth of the business assets and account for one-third of total business entities in the United States.2 That presence is the result of unprecedented growth over the last several years-growth that promises to continue based on recent trends. In fact, tax partnerships are increasing in number, and their business activity is growing in both absolute and relative terms.3 For example, during the eight-year period ending with 2007, the number of tax partnerships increased 50%.4 The value of assets held by tax partnerships increased almost threefold to $20 trillion, the amount of tax partnership income doubled to $4 trillion, and the amount of depreciation deductions taken by tax partnerships increased significantly. 1. To illustrate the size of tax partnerships, in 2007, the largest 18,417 (of 3 million) tax partnerships held more than $15 trillion in total assets and had $2 trillion of total income. On average, each of those partnerships held $814 million of assets and had $109 million of total income. See INTERNAL REVENUE SERV., ALL PARTNERSHIPS: TOTAL ASSETS, TRADE OR BUSINESS INCOME AND DEDUCTIONS, PORTFOLIO INCOME, RENTAL INCOME, AND TOTAL NET INCOME BY SIZE OF TOTAL ASSETS, 2007 tbl. 15 (2007), available at http://www.irs.gov/taxstats/bustaxstats/article/ 0,,id=130919,00.html (follow "2007" hyperlink under "All Partnerships" heading). See also infra text accompanying notes 211-218 (illustrating the use of tax partnerships by a smaller property owner and a multinational corporation). 2. See infra notes 6-7 and accompanying text. 3. Commentators note with fascination the proliferation of unincorporated entities (most of which are likely tax partnerships) over the last several years. See, e.g., Robert J. Rhee, Bonding Limited Liability, 51 WM. & MARY L. REV. 1417, 1445-46 (2010) (illustrating that the number of limited liability company filings in three major states for the five-year period ended in 2008 increased by 10.6%, while the number of corporate filings decreased by 1.2% during the same period and suggesting states should require such entities to post bond to do business in the states); Larry E. Ribstein, Uncorporating the Large Firm 34 (Ill. L. & Econ. Research Paper Series, Research Paper No. LEO8-016, 2008), available at http://papers.ssm.com/pape.tar?abst ract id=1003790 (examining the use of unincorporated entities as vehicles for equity funds and large publicly traded ventures). The amount of assets partnerships hold and the income and deductions they account for also speak to the role partnerships now play in the economy. See INTERNAL REVENUE SERV., ALL PARTNERSHIPS: TOTAL ASSETS, TRADE OR BUSINESS INCOME, RENTAL INCOME, AND TOTAL NET INCOME, BY SELECTED INDUSTRIAL GROUP, 2007 tbl. 1 (2007) [hereinafter THE 2007 PARTNERSHIP STATISTICS], available at http://www.irs.gov/taxstats/ article/0,,id=201174,00.html (follow "2007" hyperlink). Based on 2007 estimates, partnerships hold $20 trillion of assets, have $4.2 trillion of income, and receive $3.9 trillion of deductions. Id. 4. In 2000, the IRS reported 2 million tax partnerships. See INTERNAL REVENUE SERV., ALL PARTNERSHIPS: TOTAL ASSETS, TRADE OR BUSINESS INCOME AND DEDUCTIONS, PORTFOLIO INCOME, RENTAL INCOME, AND TOTAL NET INCOME FOR SELECTED INDUSTRIAL GROUPS, 2000 tbl. 1 (2000) [hereinafter THE 2000 PARTNERSHIP STATISTICS], available at http://www.irs.gov/taxstats/article/ 0,,id=201174,00.html (follow "2000" hyperlink). In 2007, the IRS reported approximately 3 million tax partnerships. See THE 2007 PARTNERSHIP STATISTICS, supra note 3. The Article uses this time period because its recent and relevant data are easily accessible for the years under observation. 5. Tax partnerships held approximately $6.7 trillion of assets in 2000, see THE 2000 PARTNERSHIP STATISTICS, supra note 4, and $20 trillion in 2007, see THE 2007 PARTNERSHIP STATISTICS, supra note 3. Tax partnership income was approximately $2.2 trillion in 2000, see THE 2000 PARTNERSHIP STATISTICS, supra note 4, and $4.2 trillion in 2007, see THE 2007 PARTNERSHIP STATISTICS, supra note 3. Tax partnerships claimed approximately $59 billion of depreciation 1080 UNIVERSITY OF CINCINNATI LAW REVIEW [Vol.79 The relative growth of tax partnerships is staggering. The number of tax partnerships as a percent of total business entities increased from 29% to 33% between 2000 and 2007.6 The percent of business assets held by tax partnerships increased from 13% to 20% during that same time period.7 Comparing tax partnership income to U.S. Gross Domestic Product (GDP) reveals that partnership income grew significantly faster than GDP.8 These comparisons, as summarized in Table 1, illustrate that tax partnerships are a significant part of the economy; analysts and commentators can no longer neglect their presence. deductions in 2000, see THE 2000 PARTNERSHIP STATISTICS, supra note 4, and approximately $86 billion in 2007, see THE 2007 PARTNERSHIP STATISTICS, supra note 3. 6. In 2000, the IRS reported approximately 5 million tax corporations and 2 million tax partnerships. See INTERNAL REVENUE SERV., NUMBER OF BUSINESSES, BUSINESS RECEIPTS, NET INCOME, AND DEFICIT, BY FORM OF BUSINESS AND INDUSTRY, TAx YEAR 2000 tbl. 3 (2000) [hereinafter THE 2000 GENERAL BUSINESS STATISTICS] available at http://www.irs.gov/taxstats/ bustaxstats/article/0,,id=152029,00.html (follow "2000" hyperlink). In 2007, the IRS reported approximately 5.9 million tax corporations and approximately 3 million tax partnerships. See INTERNAL REVENUE SERV., NUMBER OF BUSINESSES, BUSINESS RECEIPTS, NET INCOME, AND DEFICIT, BY FORM OF BUSINESS AND INDUSTRY, TAx YEAR 2007 tbl. 3 (2007) [hereinafter THE 2007 GENERAL BUSINESS STATISTICS], available at http://www.irs.gov/taxstats/bustaxstats/article/0,,id=152029,00.html (follow "2007" hyperlink). The number of business entities does not include sole proprietors. 7. Tax corporations held approximately $81 trillion of assets in 2007. See INTERNAL REVENUE SERV., 2007 CORPORATION SOURCE BOOK OF STATISTICS OF INCOME: U.S. TOTAL: RETURNS WITH AND WITHOUT NET INCOME (2007), available at http://www.irs.gov/taxstats/article/0,,id=165716,00.html. Tax corporations held approximately $47 trillion of assets in 2000. See INTERNAL REVENUE SERV., 2000 CORPORATION SOURCE BOOK OF STATISTICS OF INCOME: U.S. TOTAL: RETURNS WITH AND WITHOUT NET INCOME (2007), available at http://www.irs.gov/taxstats/bustaxstats/article/ 0,,id=178035,00.html. 8. In 2000, U.S. GDP was approximately $10.3 trillion (compared to $2 trillion of tax partnership income) and approximately $14 trillion (compared to $4 trillion of tax partnership income) in 2007. See Bureau of Econ. Analysis, National Economic Accounts: National Income and Produce Accounts Table: Table 1.1.5, Gross Domestic Product, http://www.bea.gov/national/nipaweb/ SelectTable.asp (follow "Table 1.1.5. Gross Domestic Product (A) (Q)" hyperlink) (last visited Feb. 5, 2011). 2011] PARTNERS' INTERESTS INA PARTNERSHIP 108 1 Table 1 Recent Growth of Tax Partnerships Absolute Growth of Tax Partnerships Metric 2000 2007 Number of Tax Partnerships 2 Mill. 3 Mill. Assets held by Tax Partnerships $7 Trill. $20 Trill. Tax Partnership Income $2 Trill. $4 Trill. Tax Partnership Depreciation Deductions $59 Bill. $86 Bill. Relative Growth of Tax Partnerships Tax Partnerships/Total Business Entities 29% 34% Tax Partnership Assets/Total Business Assets 13% 20% Tax Partnership Income: U.S. GDP 1:5 1:3.6 This information about the growth of tax partnerships and the potential abuses identified in this Article signal a troubling trend. Business and property owners often form tax partnerships to avoid the corporate double tax.9 Once in tax-partnership form, many owners will take further steps to reduce their tax liabilities. The partnership tax allocation rules appear to facilitate such efforts, and with trillions of dollars at stake, tax-reduction schemes could further cripple the government's ability to raise tax revenue and tame the unwieldy deficit. Tax-planning opportunities exist with tax partnerships because of complex (and often ambiguous) partnership tax rules. Partnership tax rules generally apply to all non-corporate multiple party business arrangements.'0 Thus, general partnerships, limited partnerships, and limited liability companies are generally subject to partnership tax rules." Arrangements that are subject to partnership tax rules are tax partnerships. The complexity of the partnership tax rules derives in part from the nature of tax partnerships. Tax partnerships do not pay income tax; instead, all partnership income flows through to the partners, and they report it on their individual returns.12 Each partner reports a share of the income in accordance with the partnership tax allocation rules.13 9. See I.R.C. § 11 (a) (2006) (imposing a tax on corporations); I.R.C. § 61(a)(7) (2006) (including corporate dividends in gross income). 10. See I.R.C. §§ 701-777 (2006) (governing the taxation of partners and partnerships); Treas. Reg. § 301.7701-2 (as amended in 2009) (defining tax corporation generally as an incorporated entity); Treas. Reg. § 301.7701-3 (as amended in 2006) (providing that business entities with more than two members that are not tax corporations are tax partnerships). 11. Such arrangements may, however, elect to be taxed as corporations subject to corporate tax. See Treas. Reg. § 301.7701-3(a) (as amended in 2006). 12. See I.R.C. § 701 (2006). 13. See I.R.C. §§ 702, 704 (2006). 1082 UNIVERSITY OF CINCINNATILAWREVIEW [Vol.79 Tax partnerships are entities that own partnership property and provide services in which partners have indirect interests. Partnership property and services combine to generate taxable income. The partners cannot trace partnership taxable income directly from its source to the partner who contributed a particular resource.14 For example, partners cannot determine the extent to which a partnership's rental income derives respectively from partnership property and the partners' efforts to manage the property. Consequently, tax law cannot rely upon general principles of income taxation to determine each partner's share of partnership taxable income.15 Instead, partnership tax allocation rules determine the partners' shares of the income.16 In fact, allocating partnership income to the partners is the fundamental purpose and challenge of partnership taxation.17 The allocation rules rely heavily upon "partners' interests in a partnership"- a unique tax concept.'8 The allocation rules are, in turn, the heart of partnership taxation.19 Furthermore, the allocation rules can affect the partners' legal rights and obligations in the partnership. Despite the central importance of the concept of partners' interests in a partnership, commentators and politicians have largely neglected to critically examine it.20 This Article is the first to claim that partners' 14. See Bradley T. Borden, Aggregate-Plus Theory ofPartnershipT axation, 43 GA. L. REV. 717, 752-61 (2009) (discussing the use of allocations to reduce agency costs in tax partnerships and the resultant difficulties such allocations present). 15. See Bradley T. Borden, Taxing Shared Economies of Scale, 61 BAYLOR L. REV. 721, 736 (2009) ("General principles of income tax become inadequate when parties integrate resources."). 16. See I.R.C. § 704 (2006) (governing the allocation of partnership taxable income). 17. See Gregg D. Polsky, DeterringT ax-Driven PartnershipA llocations 1-2 (FSU Coll. of Law, Pub. Law Research Paper No. 436, 2010), available at http://papers.ssm.com/sol3/ papers.cfm?abstract id=1571542 ("How to allocate a partnership's tax items is the most fundamental issue in" partnership taxation.); Andrea Monroe, Saving Subchapter K: Substance, Shattered Ceilings, and the Problem of Contributed Property, 74 BROOK. L. REv. 1381, 1384 (2009) (claiming that the partnership tax allocation rules are "absolutely fundamental to the theory and practice of' partnership taxation.). 18. See I.R.C. § 704(b) (2006). 19. This Article follows the convention in the regulations and uses the terms "partners' interests in the partnership," "partner's interest in the partnership," "partner's interest in a partnership," and similar terms interchangeably as appropriate to refer to the concept. See Treas. Reg. § 1.704-l(b)(3) (as amended in 2008). 20. At least two articles have considered the technical aspects of the concept. See Bradley T. Borden, Allocations Made in Accordance with Partners' Interests in the Partnership,1 1 BUS. ENT. 4 (2009) (focusing on the technical shortcomings of the factors used to determine partners' interests in a partnership); Stephen Utz, Allocation and Reallocation in Accordance with the Partners'Interestsin the Partnership, 56 TAX LAW. 357 (2002) (observing two possible approaches for allocating items in accordance with partners' interests in a partnership). Other articles focus on allocation rules, but they neglect the importance and deficiencies of the concept of partners' interests in a partnership. See, e.g., Walter D. Schwidetzky, The PartnershipA llocation Rules of Section 704(b): To Be or Not to Be, 17 VA. TAX REV. 707, 717 (1998) (describing the allocation rules and observing that they should not be 2011] PARTNERS' INTERESTS IN A PARTNERSHIP 1083 interest in a partnership is illusory in the tax context and its use seriously flaws partnership taxation. This Article demonstrates that the flaws bleed over into legal and economic aspects of tax partnerships. This Article claims that because of the central role of partners' interests in a partnership, its illusory nature undermines partnership taxation, and nothing short of a fundamental reform will remedy the deficiency. Commentators and politicians' neglect appears to derive from two phenomena. The first is path dependency; partnership tax experts expend considerable time and energy mastering the complicated partnership tax allocation rules, and they embrace that which they master. The second is tax myopia; partnership tax experts often focus narrowly on tax law and neglect the broader context in which tax issues arise. This Article introduces three correlatives to place the rules in a broader context, to break down tax myopia, to help frame the issues, and to lead to better rules. It suggests that the allocation rules must account for the correlation between: (1) economic items and tax items; (2) state law and tax law; and (3) partners' economic interests and partners' interests in the partnership. The three correlatives, as depicted in Table 2, are crucial to analyzing partners' interests in a partnership, and the analysis this Article models illustrates how the correlatives will facilitate analyses of other aspects of partnership taxation. Table 2 Partnership Correlatives Economic Items 4 - 0 Tax Items State Law 4 I, Tax Law Economic Interests Partners' Interests Part I of this Article explores the first correlative. That Part illustrates the responsibility the law has to govern the allocation of tax items and how taxpayers may take advantage of deficient allocation rules to reduce the amount of tax they would otherwise owe. Part II of this Article discusses the second correlative-the distinction between state law allocation rules and the partnership tax allocation rules. That Part illustrates that the two bodies of law are intertwined and that taxpayers reformed); Lawrence Lokken, PartnershipA llocations, 41 TAX L. REV. 545, 613 (1986) (discussing the allocation rules generally but noting specifically that "partners' interests are not as easily determined in many cases"). Recent scholarship in this area calls for changes to other parts of the allocation rules. See, e.g., Polsky, supra note 17 (recommending changes to the test for substantiality and the rules governing allocation of built-in gains and losses, respectively); Monroe, supra note 17 (same). 1084 UNIVERSITY OF CINCINNATI LAW REVIEW [Vol.79 may unwittingly alter their intended legal and economic arrangement by adopting the partnership tax allocation rules' economic effect safe harbor. That Part also demonstrates how the current allocation rules are tax-centric because they cause economic items to follow the allocation of tax items. Part III describes partners' interests in a partnership as a unique tax concept and distinguishes it from partners' economic interests. That Part also illustrates that the concept is illusory when used in the tax context. Part IV proposes fundamental changes to the rules that would eliminate the shortcomings in the current law and move to item-specific economic-centric tax-item allocations. I. CORRELATIVE ONE: ECONOMIC ITEMS AND TAX ITEMS The analysis of partners' interests in a partnership begins with the distinction between economic items and tax items. An economic item is a metric that expresses economic activity; a tax item is an amount reported on a tax return. An example of an individual taxpayer illustrates the difference between economic items and tax items. Employees receive cash payment for services. The cash payment is an economic item. It has a corresponding tax item-compensation income. Tax law requires employees to report compensation income on their tax returns.21 Because the tax item corresponds to an economic item, it is a corresponding tax item.22 Employers often pay a portion of their employees' health insurance premiums as a part of their compensation, and those payments are economic items. Tax law does not require employees to report such payments as income on their tax returns. 23 Therefore, employees often receive an economic item that has no accompanying tax item. Finally, an individual may own depreciable property. Tax law allows the individual to claim a depreciation deduction regardless of fluctuations in the property's value.24 Thus, the property owner will generally have a tax item that does not correspond to an economic item. Tax items that have no corresponding economic items are independent tax items. Allocating corresponding and independent tax items to individuals is fairly simple. An individual who provides services must 21. See I.R.C. § 61(a)(1) (2006). 22. See infra Part I (discussing the allocation of economic items and corresponding tax items). 23. See I.R.C. § 106 (2006). 24. See I.R.C. § 167(a) (2006) (allowing the deduction for depreciation); Simon v. Comm'r, 103 T.C. 247, 261 (1994), af'd 68 F.3d 41 (2d Cir. 1995) ("[S]ection 168 does not support [the] proposition that a taxpayer may not depreciate a business asset ... due to the fact that the asset may have appreciated in value over time."). 2011] PARTNERS' INTERESTS INA PARTNERSHIP 1085 report the tax items associated with those services, 25 and an individual who owns property must report the tax items associated with the property.26 Allocating tax items in the partnership context can be difficult. A tax partnership with $100,000 of rent receipts will also have $100,000 of rental income, which is a corresponding tax item. Intuition suggests that the partnership should allocate the corresponding tax item in the same manner in which it allocates the economic item. Partners dissociate economic items and tax items when they allocate them in different ratios to the partners. The allocation rules should prevent the partners from dissociating economic items and corresponding tax items. A tax partnership with depreciable property will have a depreciation deduction-an independent tax item. Because of the flow-through nature of tax partnerships, the partnership must allocate independent tax items to partners, even though the tax items do not correspond to economic items. The allocation of independent tax items may not be intuitive, but the allocation rules must address the allocation of such items. If the allocation rules do not prevent the dissociation of economic items and corresponding tax items and adequately address the allocation of independent tax items, partners will be able to use partnership tax items to reduce their overall tax liability and commit other abuses.27 This Article claims that the current partnership tax allocations rules fail to adequately prevent partners from dissociating tax items from corresponding economic items, and that the rules governing the allocation of independent tax items are deficient. A more detailed example illustrates why partners might try to dissociate corresponding tax items and demonstrates how partners can use the allocation rules abusively. A. Economic and Tax Items of a Typical Tax Partnership The following fact pattern is fairly typical, and it helps illustrate concepts discussed throughout this Article. Sam and Claire form Samaire Partnership on January 1, Year 1. Sam contributes $800,000, and Claire contributes $200,000 to the partnership. The partnership immediately uses the money to purchase an office building, which it 25. See Lucas v. Earl, 281 U.S. 111, 114-15 (1930) (providing that a taxpayer may not assign the obligation report income from services to another person). 26. See Helvering v. Horst, 311 U.S. 112, 114, 119-20 (1940) (requiring the owner of property to report income derived from the property). 27. See infra Part 11.B (illustrating the potential for such abuse).