When Professor Andrea Monroe was interviewed by Paul Caron, she confessed that her childhood ambition had been to become the Commissioner of Major League Baseball. Her backup plan was to teach high school history. Instead she teaches tax law at Temple University. Her recent paper, Integrity in Taxation : Rethinking Partnership Tax, shows that she did not entirely renounce her girlhood ambitions. There is some great historical analysis and she has focused on the area of taxation that is almost as complicated as the infield fly rule. She gives a great description of what a mess partnership taxation is and the series of events that have brought us there. Her proposal that we can fix the situation by applying the concept of integrity may be a tad optimistic, but that may just be my cynical old age showing through.
The Problem of Partnership Taxation Or Why Otherwise Sensible People Choose To Incorporate
I often run into situations both in reading tax cases and real life where it is clear that people would have been better off if they had chosen the partnership form. The usual answer I get when I raise the issue is that the form is too complicated. I actually kind of like the answer. It is nice to know a good bit about something that has a lot of people mystified. Professor ]Monroe’s article describes the problems facing practitioners quite well.
Partnership taxation has been described as a mess, a disaster, and a magic circle of tax abuse. Additionally, there are thousands of pages of rulings, memoranda, and guidance, both formal and informal, clarifying the application of these provisions in specific situations. Although the sheer quantity of partnership authority introduced great complexity into subchapter K, the deeper problem relates to their design. As previously discussed, subchapter K’s provisions are largely technical, involving specialized language, multi-factored tests, and computational analyses that challenge all but the most experienced partnership tax specialist.
That “except for the most experienced partnership tax specialist”. Really what it is is that we just don’t let on how challenged we are.
How Did It Get This Way ?
There is a cautionary tale for prospective tax reformers in the story of how what, in principle, should be something simple got to be so complicated. Partnership taxation, at least since the seventies, has been the primary battleground in the war against tax shelters.
By the time Congress decided to more aggressively pursue partnership tax abuse, it was too late; the government had already fallen behind in the fight against tax shelters. The Treasury possessed neither the time, money, nor resources to match the cadre of professionals who marketed abusive partnership transactions. The government thus found itself perpetually responding to the last tax shelter rather than preventing the next tax shelter.
Subchapter K today is a diffuse system directed at tax shelters and at the unpredictable activities of sophisticated partnerships. Yet subchapter K’s provisions govern all partnerships, even entities whose commercial activities share nothing in common with the elaborate transactions of sheltering partnerships. In the polarized world of modern partnerships, subchapter K focuses virtually all of its attention on the minority of partnerships at the tax shelter extreme, thereby leaving large numbers of non-sheltering partnerships in a precarious position –wanting to comply with the law, but finding themselves unable to do so without the expenditure of excessive, often cost prohibitive, resources.
Partnerships are to our income tax system as airlines are to our transportation system. They are the quickest way to legitimately get from Point A to Point B, but the rules for using them are designed with the people who are trying to blow up the tax system in mind. Remind me why we have to take off our shoes and get groped to get on an airplane. Partnership regulations address “mixing bowls” for similar reasons.
Partnership taxation today is best described as a loose collection of ad hoc measures designed, in large part, to combat tax shelters. And herein lies a problem with subchapter K – it is a conglomerate of provisions tied together by little more than necessity, political force, and the fact that its provisions all begin with the section number “700′.
Is Integrity The Answer ?
A legal system with integrity almost inevitably sacrifices some justice and some fairness in individual instances to provide a system that, as a whole, is considered just and fair. Such an integrity based system speaks with a coherent voice, applying the same balance of justice and fairness to all its citizens, thereby easing the discord between these fundamental principles of law.
Professor Monroe believes that the rules for partnerships should not be based on what is being done by illegitimate tax shelters. Rather they should be based on the realities of the large number of businesses that are not trying to get away with anything and desire to be compliant. In another paper, for example, she suggest a two tier allocation scheme which would allow partnerships with simpler capital structures to use an allocation scheme similar to the straight-forward per share per day rule of S corporations. The baseball commissioner is coming through there again. It is kind of like the way they let the college kids use aluminum bats.
As far as the tax shelters go, she would prefer that they be addressed by relying on tax provisions of general application – provisions outside of subchapter K – in addressing the abusive transactions entered into by sheltering partnerships.
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Originally published on Forbes.com Feb 5th, 2013