Deterring Tax-Driven Partnership Allocations
28 Pages Posted: 22 Mar 2010 Last revised: 24 Apr 2010
Date Written: March 15, 2010
How to allocate a partnership’s tax items is the most fundamental issue in subchapter K of the Internal Revenue Code, which governs the taxation of limited liability companies, limited liability partnerships, limited partnerships, general partnerships, joint ventures, and other unincorporated business entities. The principal concern is that the flexibility afforded to partners under subchapter K could be used to trade tax attributes among the partners. For the past twenty-five years, an extremely lengthy and complex set of regulations, known as the substantial economic effect regulations, has been the government’s primary defense against the trading of tax attributes through partnerships. However, despite their importance, age, length, and complexity, these regulations have not yet been adequately examined in detail. This Article identifies, for the very first time, a number of critical implicit assumptions underlying the substantial economic effect regulations. Most significantly, the Article shows that, unless partners are highly risk averse in seeking the benefits of trading in tax attributes, these regulations should be wholly ineffective. Even if partners are risk averse, the possibility of hedging or tacit agreements among the partners must be considered. Ultimately, whether the substantial economic effect regulations are reasonably effective depends on a number of empirical questions, such as partners’ level of risk adverseness and the transaction costs of hedges and tacit agreements. In addition to identifying the critical implicit assumptions of the substantial economic effect regulations, this Article also makes specific recommendations for the Treasury Department and the Internal Revenue Service to implement in order to make them more effective.
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