Circular Partnerships

Abstract

Partners are responsible for the tax on income earned by their partnerships: whether or not actually distributed, the income “flows through” the partnership to its partners for tax purposes. A partnership can have partners that are also partnerships, and, recursively, partnership-partner chains of any length may arise. In such cases, the income continues to flow through the chain link by link. But such a chain may at some point return to the original partnership; a partnership may be an indirect partner in itself, and a flow-through cycle may thus be created. We study the phenomenon of partnership ownership cycles in light of the concern, recently expressed by prominent experts and policy makers, that a substantial amount of income goes untaxed as it “flows endlessly between partnerships that own each other.” We examine the best empirical research on circular partnerships and find that, despite how that work has been deployed in policy discourse, it has little to say on the specific question of how much income is trapped in circular partnership structures. We then examine such structures from both a mathematical and legal perspective in order to gain a better understanding of the precise nature of the problem. We find that current law goes farther than one might imagine toward preventing untaxably trapped income. Where we judge current law to be inadequate or inappropriate, we suggest reforms.

Keywords: Partnership taxation, Pass-through taxation, Tax-transparent entities, Circular partnerships, Circular partnership structures, Partnership cycles, Ownerships cycles, Unsolved partnerships, Superseding returns, Centralized Partnership Audit Regime, CPAR, BBA, Administrative Adjustment Requests, AAR

JEL Classification: K34, H25, H26, K22, C60, C65, C63