Partnership Tax Allocations and the Internalization of Tax-Item Transactions

50 Pages Posted: 27 Sep 2007 Last revised: 14 Mar 2008


Studies in the theory of the firm help explain partnership attributes and the relationships partners have with each other, which in turn inform the analysis of partnership tax allocation rules. Those studies suggest that partners apportion partnership economic items (such as income and loss) to each other to reduce partner shirking, opportunistic behavior, and agency costs. But partnerships are complex communities of interest, so partners are often unable to determine the specific source of partnership economic items (i.e., they cannot trace partnership output directly from partner input). Therefore, apportioned amounts of partnership items may contain several different and inseparable economic items attributable in indeterminable proportions to contributions from the partners. Furthermore, economic theory implies that partnerships, to reduce transaction costs, internalize transactions that would otherwise occur on the open market. Partnership tax allocation rules should account for such economic principles. Unfortunately, the current discretionary partnership tax allocation rules ignore economic theory and allow partners to separate tax items from economic items and engage in tax-item transactions that are prohibited on the open market. That internalization of tax-item transactions violates fundamental tax principles. Commentators recognize that problem and frequently recommend that partnership tax allocations should follow partner capital accounts. Rigid allocation rules do not, however, account for the economic nature of partnerships. This Article therefore proposes that the partnership tax allocation rules should recognize the partners' economic arrangement as expressed in the partners' apportionment of economic items and require tax partnership items to follow partnership economic items.

Keywords: partnership allocations, section 704(b), theory of the firm, tax-item transactions

JEL Classification: H25, H26, K34, G32

Suggested Citation

Borden, Bradley T., Partnership Tax Allocations and the Internalization of Tax-Item Transactions. South Carolina Law Review, Vol. 59, p. 297, 2008, Available at SSRN:

Bradley T. Borden (Contact Author)

Brooklyn Law School ( email )

250 Joralemon Street
Brooklyn, NY 11201
United States


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