Partnership Taxation Is The Brain Surgery Of Tax Law But Shouldn't Have To Be

Partnership taxation is the most intellectually challenging part of federal tax law. Done right, it usually comes to the intuitively correct solution, but the way it gets there is rarely intuitive. This is a problem of increasing importance. Since the vast majority of limited liability companies (LLCs) with more than one member are governed by partnership accounting rules, that were previously used much less widely and are often micro-businesses run by amateurs, this issue has become far more pressing that it used to be.

There are a couple of things that make it particularly difficult. One is that allocation of entity level items of revenue and expense and credits are not necessarily linked directly to actual cash transactions with partners. The other is that there is a parallel set of accounts for inside and outside basis whose reconciliation is tricky.

The Tax Profs blog notes:

Andrea Monroe’s article, Making Tax Law Work: Improvisation and Forgotten Taxpayers in Partnership Tax, boldly calls on partnership tax experts to understand their role in normalizing dysfunction within partnership tax law and to support reform that is mindful of all partnerships.

Although millions of business entities are taxed as partnerships, assets and income are concentrated in a small number of them. As Monroe notes, drawing on IRS data from 2018, “less than 1 percent of partnerships held greater than 76 percent of partnership assets, and approximately 73 percent of partnerships held roughly 1 percent of partnership assets.” This suggests great differences among tax partnerships, yet, as partnership income and deductions are taxed to the partners and not the partnership, all tax partnerships must allocate their income and deductions to their owners. ...

Andrea Monroe’s article is a critical and timely reminder that the tax system, including the highly difficult portion applicable to tax partnerships, “only works if the vast majority of [taxpayers]—whether rich or poor, forgotten or elite—can participate.”

The paper and its abstract are as follows:

There is a growing awareness that federal tax law caters to a small number of wealthy and well-advised taxpayers without regard for the rest of the taxpaying public, and partnership tax is a prime example. This article explains how complexity and indeterminacy have transformed partnership tax, harming millions of forgotten taxpayers who struggle to comply with their annual filing obligations. A root cause of this phenomenon is the professional culture of elite practitioners, policymakers, and scholars at the heart of the partnership tax system.

The most troublesome provisions of partnership tax are also its most fundamental, namely the allocation rules that regulate how partners share a partnership’s taxable items. Complexity is a universal problem faced by partnerships at all levels of wealth, status and sophistication, and the vast majority of taxpayers respond with improvisational tax compliance. In remarkably diverse contexts, improvisation has replaced technical compliance as the norm in partnership allocations. Wealthy partnerships make a strategic choice to improvise, using “target allocations,” while poorer partnerships improvise because they have no other choice, routinely following “intuitive” tax law and hoping for the best.

Reframing this complexity problem as a shared experience of all partnerships exposes the technical and cultural fractures of partnership tax in a new and different light. First, the technical rules governing partnership allocations do not work as designed for any category of partnership. A second, less explored problem is the professional culture of partnership tax, which takes for granted the technical sophistication of substantive tax law without appreciating the distributional consequences of sustained complexity and improvisation.

Partnership allocations require more than technical solutions. One necessary step is addressing the professional culture of partnership tax to rethink what it means for tax law to work. This article proposes that partnership reforms developed by experts and directed at wealthy and well-advised partnerships should be accompanied by reforms addressing parallel problems faced by forgotten partnerships. The solutions will necessarily differ, but a bilateral focus on the universal problems of all partnerships would represent meaningful progress, signaling a commitment to a fair, principled, and representative system of partnership tax.

Monroe, Andrea, Making Tax Law Work: Improvisation and Forgotten Taxpayers in Partnership Tax (May 1, 2021). University of Michigan Journal of Law Reform, Forthcoming, Temple University Legal Studies Research Paper No. 2021-23, Available at SSRN: https://ssrn.com/abstract=3838058