25 March 2008

On Partnership Taxation

"Partnership taxation probably is the epitome of what's wrong with the tax system."

From Mauled Again which discussed why this is the case in detail.

The amount of tax due in most, but not all, situations is lower in partnership taxation than in C corporation taxation, but this comes at the cost of having to deal with among the most heinously complex parts of the tax code. (Subchapter S corporation tax law is much less complex than partnership taxation and produces similar although not identical tax liabilities, but is less flexible.) It also doesn't help that most big corporations can afford expensive legal counsel to handle the hard issues, which often come up primarily in big business settings. In contrast, partnerships are often small ventures with little room in their budget for tax counsel or a tax accountant.

The widespread use of limited liability companies, limited liability partnerships, limited liability limited partnerships, limited partnership associations, and assorted other spawn of the check the box rules have made the problem profoundly worse, because Subchaper K was written with the assumption that some or all partners have unlimited liability and many Subchapter K rules are awkward at best and simply do not work at all, at worse, in non-recourse regimes.

Yet, as I explained to my continuing education class on asset protection yesterday, no sane person should ever use a general partnership by itself as their sole business entity, even though there are select circumstances when a sole proprietorship should be preferred to a single owner corporation or LLC. General partnerships are the default regime of the uncounseled, or arise accidentally.

General partnerships can also be a pain to deal with from a non-tax internal management perspective, in addition to their obvious asset protection flaws. I can affirm from experience that a general partnership breakup is an ugly thing and that the uniform laws adopted in Colorado and almost everywhere to deal with them are inadequate to address the issues that arise in practice. This happens mostly because important practical issues like who controls the entity during the breakup, who the proper parties are to litigation, and how discovery is handled are not adequately addressed in the manner that they come up in real life by the statute.

Subchapter K was hard enough, however, even before completely limited liability entities appeared. For example, my clients almost always find the distinction it makes between allocation of items of profit and loss on one hand, and distributions of partnership assets on the other, to be difficult to understand and counterintuitive. Do it yourself partnership agreements are frequently ambiguous in practice as a result of failing to make that distinction.

Alas, tax law is not driven by small general partnerships, LLCs and LLPs, but by highly sophisticated financial transactions designed using the tool of Subchapter K of the tax code which governs partnerships. As Maule explains, the reason that this is not reformed, despite the fact that it wouldn't be terribly hard to adopt reforms is that:

Simplification attempts would . . . be opposed by those who have advantages under the current system that they would lose if the partnership provisions were simplified. The same, unfortunately, can be said about most other areas of the tax law, though perhaps not quite to the extreme level as afflicts partnerships.

One possibility would be a safe harbor regime for reasonable simple LLCs and LLPs. Another would be to simply follow the example of the 1986 tax reform and simplify the law on a revenue neutral basis notwithstanding the fact that all sorts of special interests would be offended as a result.

1 comment:

Andrew Oh-Willeke said...

This paper is more positive about Subchaper K and sees it as only modestly flawed.