The Allure and Illusion of Partners’ Interests in a Partnership

Abstract

Favorable tax treatment and management flexibility make tax partnerships very popular. For starters, tax partnerships, unlike tax corporations, are not subject to entity-level taxes. Partnership taxable income flows through to the partners, and the partners report their shares of partnership taxable 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 difficult 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 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.

Keywords: partnership tax allocations, partners’ interests in a partnership