Too Big to Fail: The Problem of Partnership Allocations

Abstract

The partnership taxation rules of subchapter K are uniquely flawed. Designed to be flexible, subchapter K must accommodate a diverse and growing array of business organizations, from the most simple to the most sophisticated. Yet such flexibility, combined with subchapter K’s complexity and low enforcement resources, has made partnerships the preferred vehicle for many tax shelter transactions, imposing extraordinary costs on the public at large. The crisis in partnership taxation is well understood within the tax community, but solutions to subchapter K’s formidable problems have been slow to emerge.

This Article proposes to stabilize partnership taxation through the reform of its most critical, and most problematic, provisions: the rules governing partnership allocations. Although the partnership allocation provisions are the operational lifeblood of subchapter K, these allocation rules have failed, no longer providing partnerships with a viable means of dividing taxable items among their partners.

This Article thus offers a novel reform of the partnership allocation provisions. Specifically, it proposes that the Treasury Department adopt a penalty default approach to partnership allocations, forcing partnerships to separate themselves based on their identity as either simple or sophisticated partnerships. In doing so, the Treasury could adopt allocation rules better designed to address the diverse needs of modern partnerships; simple 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. Indeed, introducing a penalty default rule into the partnership allocation provisions would result in a more equitable and more administrable subchapter K.

Keywords: partnership tax, partnership allocations, penalty default, Section 704, substantial economic effect

JEL Classification: K34