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Enforcing the Fundamental Premises of Partnership Taxation Rebecca S Hofstra Law Review Volume 22 | Issue 2 Article 1 1993 Enforcing the Fundamental Premises of Partnership Taxation Rebecca S. Rudnick Follow this and additional works at: http://scholarlycommons.law.hofstra.edu/hlr Part of the Law Commons Recommended Citation Rudnick, Rebecca S. (1993) "Enforcing the Fundamental Premises of Partnership Taxation," Hofstra Law Review: Vol. 22: Iss. 2, Article 1. Available at: http://scholarlycommons.law.hofstra.edu/hlr/vol22/iss2/1 This document is brought to you for free and open access by Scholarly Commons at Hofstra Law. It has been accepted for inclusion in Hofstra Law Review by an authorized administrator of Scholarly Commons at Hofstra Law. For more information, please contact [email protected]. Rudnick: Enforcing the Fundamental Premises of Partnership Taxation HOFSTRA IAW RIEVIEW Volume 22, No. 2 Winter 1993 ENFORCING THE FUNDAMENTAL PREMISES OF PARTNERSHIP TAXATION Rebecca S. Rudnick* CONTENTS I. INTRODUCTION ............................ 232 11. CAPITAL ACCOUNTS AND AREAS OF CONTROVERSY .... 241 A. Capital Account Maintenance ......... .... 242 B. Examples to Illustrate Areas of Controversy .... 244 1. Income Allocations-Sharing Profits and Losses Differently During Different Years .... 244 2. Character-Shifting Allocation .......... .... 245 3. Service Contribution ............... .... 245 4. Contribution of Property ............ .... 246 5. Distribution of Property Non-Pro Rata .... .... 246 * Visiting Associate Professor of Law, Boston University School of Law. B.A. 1974, Willamette University; J.D. 1978, University of Texas; LL.M. 1984, New York University. An earlier version of this Article was presented at the George Mason School of Law, Law and Economics Workshop, in November 1991. 1 thank Robert Anthoine, Evelyn Brody, Jennifer J.S. Brooks, Glenn E. Coven, Susan Pace Hamill, Sherwin Kamin, Kellye Y. Testy, and Stephen G. Utz for comments on an earlier draft. I thank my family in the San Joaquin Valley of California for impressing upon me the utility and benefits of partnerships. I also thank Carl S. Shoup, who suggested to me the importance of thinking about how the income tax system deals with losses. The errors in translation of the general to the particular are, of course, my own. A number of research assistants have helped me with my "partnership tax project" over the years: Mike Schraeder, Lester Law, Van Zimmerman, Tracy Curtner, Valerie Gulick. Connie Lee, and Deborah Friendly. I especially thank John Ferguson. Copyright ©, 1993, Rebecca S. Rudnick. Published by Scholarly Commons at Hofstra Law, 1993 1 Hofstra Law Review, Vol. 22, Iss. 2 [1993], Art. 1 HOFSTRA LAW REVIEW [Vol. 22:229 C. Pooling and Unpooling ................. 247 m. BUSINESS TAXATION AND THE PARTNERSHIP AGGREGATE MODEL ................. 248 A. Business Taxation at the Crossroads ......... 248 B. Nature of the Partnership and the Aggregate Model ..................... 254 IV. FORMULATING PARTNERSHIP TAX RULES IN THE SECOND BEST WORLD OF A HYBRID INCOME CONSUMPTION TAX ......................... 259 A. What is the Best Tax System for Subchapter K's Fundamental Premises in a Second-Best World? ................... 260 B. Formulating Partnership Tax Rules in a Second-Best World .................... 264 V. THE ROLE OF RISK-BEARING AND RISK AVERSION IN PARTNERSHIP TAXATION ................... .. 266 A. Risk-Bearing and Risk-Sharing ........... 267 1. Defining Risk and Uncertainty ........... 267 2. Risk-Taking and Risk-Sharing- Entrepreneurism and Economic Development 270 B.. Decision Making in a Tax and No-Tax World- Risk-Taking with Risk Aversion .......... 273 1. Risk Aversion-Absolute and Relative ...... 275 2. Effect of Incomplete Loss Offsets and Risky Returns on Partnerships ............... 278 3. Bargaining in a Firm for Returns from Labor and Capital .................. 281 C. Risk-Taking and Risk-Pooling ........... 283 D. The Tax Response to Risk: The Pool of Capital Doctrine ................... 286 VI. EFFICIENCY OF PARTNERSHIPS AND RISK-BEARING ... 287 A. Agency Costs and Risk-Sharing .......... 287 B. Optimal Risk-Bearing and Agency Problems . 292 C. PartnershipsAre Efficient .............. 295 D. Risk-Bearing and Its Effect on Financial and Human Contributions and Risk-Sharing Through Special Allocations .... 299 http://scholarlycommons.law.hofstra.edu/hlr/vol22/iss2/1 2 Rudnick: Enforcing the Fundamental Premises of Partnership Taxation 1993] PARTNERSHIP TAXATION VII. EFFICIENCY AND EQUITY ......... ............ 304 A. Optimal Taxes and Efficiency . ............ 305 1. In General ............. ............ 305 2. Optimal Tax Response to Risk and Partnerships ...... ............ 308 B. Equitable Concerns in Taxation ............ 315 VIII. APPLICATION AND RECOMMENDATIONS .............. 318 A. Economic Analogies- Salary, Leasing, and Borrowing ............. 319 B. Interest on Capital Accounts ............... 321 1. Role of Interest on Capital Accounts ......... 322 a. Equity Account ................... 324 b. Debt Account .................... 325 c. Debt-Equity Account ................ 326 2. Applicable Interest Rate ................. 327 3. Timing of Taxation of Interest on Positive and Negative Capital Accounts ....... 329 C. Contributions ....................... 340 1. General Principles .................... 340 2. Property Contributions .................. 340 3. Efficiency Arguments for Nonrecognition ...... 342 4. Service Contributions ................... 348 a. Receipt of Profits and Capital Interests ................... 348 b. Capitalization and Characterization of Profits Received by Service Providers .......... 351 D. Distributions ........................ 355 1. In General .......................... 356 2. The Challenge to Nonrecognition .......... 360 E. Special Allocations ..................... 372 1. In General .......................... 372 2. Substantial Economic Effect .............. 376 3. Utilization of Losses in Special Allocations .................... 380 4. In Sum ........................... 388 IX. CONCLUSION .................... ........ 389 Published by Scholarly Commons at Hofstra Law, 1993 3 Hofstra Law Review, Vol. 22, Iss. 2 [1993], Art. 1 HOFSTRA LAW REVIEW [Vol. 22:229 APPENDIX .......................................... 391 I. INTRODUCTION Federal taxation of partnerships is under intense reexamination. Embodied since 1954 in Subchapter K of the Internal Revenue Code (the "Code"), the flexible partnership taxation rules' preserve the tension between aggregate and entity theories of the partnership form.2 Since the first income tax law in 1913, partnership rules have allowed great flexibility in allocating tax events among partners.3 The four major premises of Subchapter K state that (1) contributions of property to the partnership are nonrecognition events for gains and losses;4 (2) distributions of property are nonrecognition events, 5 al- though they are subject to special rules if occurring within five years of contribution of the property and recent proposals may limit nonrec- ognition for distributions of marketable securities;6 (3) human capital 1. The 1954 revision that adopted Subchapter K to provide clarity and certainty to the prior uncertain rules of partnership taxation enacted partnership rules that provide great flexi- bility in allocating the tax burden of partnership transactions. See H.R. REP. No. 1337, 83d Cong., 2d Sess. 65 (1954) (goal of "simplicity, flexibility, and equity as between the part- ners"); S. REP. No. 1622, 83d Cong., 2d Sess. 89 (1954) (same); see also Forty Topics Pertaining to the General Revision of the Internal Revenue Code: Hearings Before the House Comm. on Ways and Means, 83d Cong., 1st Sess. 1368, 1369-70 (1953) [hereinafter 1953 House Hearings] (statement of Mark H. Johnson). 2. "Aggregate" describes an organization which does not subsume the individual charac- teristics of the owners; the organization is a conduit through which each owner acts. See BLACK'S LAW DICTIONARY 65 (6th ed. 1990). In Commissioner v. Lehman, 165 F.2d 383 (2d Cir. 1948), Judge Learned Hand noted that "it was upon this traditional structure that Congress fitted the taxation of partnerships, although it levied the income tax upon the sepa- rate distributive shares of the partners, whether they were distributed or not." Lehman, 165 F.2d at 385; see also Neuberger v. Commissioner. 311 U.S. 83, 88 (1940). In contrast, "enti- ty" describes an organization in which the organization's characteristics subsume the owners' individual characteristics. See Lehman, 165 F.2d at 385. Various results obtain when applying "aggregate" or "entity" principles and there is no consensus on what "aggregate" means. 3. See 1953 House Hearings, supra note 1, at 1369 (noting that "clarity and certainty" are more important than the end result). 4. See I.R.C. §§ 707(a)(2)(B), 721-23 (1988); Treas. Reg. § 1.707-3 (1993). An excep- tion to prevent tax-free diversification of financial assets exists for gain realized on a transfer to certain investment partnerships whose value consists of more than 80 percent in readily marketable stock, securities, and traded investments. See I.R.C. § 721(b) (1988). Income, gains, losses and deductions with respect to contributed property is allocated among the part- ners to take into account the variation between the basis of the property to the partnership and its fair market value at the time of contribution. See I.R.C. § 704(c) (Supp. 1992). 5. See I.R.C. §§ 731-33 (1988). The exception to nonrecognition and the explicit ex- change treatment
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