The Case For Two Track Partnership Taxation

Partnership taxation is the heart of darkness of tax law.

Its doctrines regarding partnership allocations can be obscure and the extra language I need in operating agreements to deal with partnership tax law (aka "Subchapter K") in limited liability companies, where one must deal with obscure rules related to non-recourse liabilities is worse.

Worse yet, the core concept of partnership tax law, that allocations of items of income and expense for tax purposes do not necessarily match actual distributions of money and property to partners, is a very counter-intuitive concept for even relatively sophisticated business people, so they tend to screw it up in informally drafted partnership agreements.

The status quo imposes immense complexity on simple partnerships, while allowing for great mischief in sophisticated partnerships.

But, in multiple owner limited liability companies, which are often the best choice of businesses that own appreciation assets that can generate legal liability, like real estate, the complexity is just a necessary sacrifice that one must make in order to receive the benefits of limited liability, without an entity level tax.

One sensible solution to the fact that so many simple businesses are subject to complex partnership taxation rules is to create a safe harbor of simpler rules for plain vanilla partnerships and limited liability companies, in which each owner owns an equal share of the business, just as they would in an S corporation.

This proposal, from tax professor Andrea Monroe, would let electing "simple" partnership use simple tax rules, while applying tougher anti-tax avoidance standard to "sophisticated partnerships." As she explains, in this proposal:

[S]imple partnerships would allocate taxable items ratably and sophisticated partnerships would allocate taxable items under an alternative regime that preserving partnership flexibility but also subjecting such allocations to an enhanced anti-avoidance standard. Separating partnerships in this manner would simplify the partnership allocation provisions, triggering an increase in compliance rates and a decrease in abusive partnership transactions.

Better yet, the proposal is designed so that it can be accomplished via tax regulation (just as the limited liability company's tax treatment was in the first place) rather than via new Congressional enactments.

The real genius of the proposal is that the "enhanced anti-avoidance standard" really isn't necessary at all. Requiring partnerships to designate themselves as "sophisticated partnerships" if they do anything but allocate taxable items ratably in proportion to their capital accounts would significantly enhance the audit process and allow for tax simplification for a large share of all entities taxed as partnerships, without opening the door to tax shelter abuse of the safe harbor simple partnership tax rules.

Simple partnerships would be simple to audit. Highly skilled partnership tax experts at the IRS, in turn, could devote their audit resources to the sophisticated partnerships that make up a small minority of all returns but present the greatest potential rewards from audits. Rather than having to find the needle in the haystack of millions of firms, auditors could focus their efforts on hundreds of thousands of firms.

It isn't a perfect solution. But, it would be a very good interim solution that would be easy to implement and provide immense relief from tax complexity to millions of American small businesses.