How to allocate a partnership’s tax items is the most fundamental issue in subchapter K of the Code, which governs the taxation of partnerships. One could envision a purely elective regime that allows partnerships to allocate items in any manner they desire. But in that case, partnerships would choose to allocate items in such a way as to minimize the partners’ aggregate tax liability; the partners would then divvy up the resulting tax windfall among themselves. In effect, an elective regime would allow partners who have favorable tax attributes (e.g., low tax rate status) to sell these attributes to other partners who are in the best position to utilize them. The end result: all of the partners would win, and the public fisc loses. Under an elective regime, partnerships would be formed simply to exploit differences in their partners’ tax attributes. Furthermore, even in a bona fide partnership (i.e., one initially formed for nontax business purposes), the owners would be better off collectively than had the business been conducted in the form of one or more sole proprietorships. Both of these effects violate the tax policy norm of neutrality, which posits that tax law should neither encourage nor discourage business decision-making, such as whether or not to form a business entity.
The problem would be particularly significant in the current U.S. tax system, where there are so many different tax attributes that could effectively be sold to the highest bidder. Some potential taxpayers are exempt from U.S. taxation, while others are nearly so because they have large net operating loss carryovers. Other taxpayers are subject to high marginal tax rates. Corporations pay ordinary tax rates on capital gains, while individuals pay preferential rates. These disparate tax attributes are simply the most obvious; the entire list could go on for pages.
As a result of the many disparate tax attributes, the current allocation system is not purely elective. While partners initially do elect how to allocate partnership tax items, the chosen allocation scheme must have “substantial economic effect” to be respected. The substantial economic effect test—which has been around for 25 years and comprises roughly 70 pages of text—has two parts. First, an allocation must have economic effect, and second, such economic effect must be substantial. The economic effect prong requires that the allocation be consistent with the economic arrangement among the partners. If the partnership allocates a $5 item of income to a partner, the allocation must increase the partner’s capital account by $5, and liquidating distributions by the partnership must be in accordance with capital accounts. Proper capital accounting ensures that the partner is better off, in pretax terms, by $5 than had she not been allocated the $5 item of income. By requiring that allocations be consistent with the economic deal, the economic effect prong is inconsistent with a purely elective regime. A purely elective regime would allow the partnership to allocate $5 of income to the partner even if the allocation had no impact whatsoever on the partner’s pretax economic consequences.
Nevertheless, the economic effect test is not much of an obstacle to the selling of tax attributes. If a partnership expects to receive different types of income or gain, or different types of deduction or loss, the partnership could—consistent with the economic effect prong—still allocate the items in a tax-advantaged way while not changing the real, overall economic deal. The partnership could do this through the use of offsetting allocations. For example, assume that, in a 50-50 partnership, partner X is tax-exempt while partner Y is taxable. The partnership could specially allocate the first $5 of its taxable income to X and the first $5 of its tax-exempt income to Y, with all other items split evenly. Assuming that the partnership earns at least $5 of taxable income and $5 of tax-exempt income, X and Y are, from a pretax perspective, in the exact same economic position that they would have occupied absent the special allocations. Nevertheless, they have effected a partial sale of Y’s tax exemption, which makes X better off by exchanging $2.50 of taxable income for $2.50 of tax-free income, Y no worse off because Y is tax-exempt, and the government worse off because it is collecting less tax revenue. The second prong of the substantial economic effect test (substantiality) is intended to inhibit this type of tax planning.
In operation, as this Article explains, the substantiality prong does not prohibit outright the selling of tax attributes through the use of partnership allocations. Instead, such a sale must be accompanied by some degree of risk that the partners’ original economic deal will be altered. If this condition is met, the attempted sale of tax attributes will be effective; if not, the sale is nullified.
This Article analyzes the theoretical soundness of the substantiality test, leaving aside the numerous practical problems in applying and administering it. The Article identifies, for the first time, a number of critical implicit assumptions underlying the test. Most importantly, the Article explains that unless partners are highly risk-averse in seeking the tax benefits of trading in tax attributes, the substantiality test simply cannot work. Likewise, even if partners are highly risk-averse, hedging opportunities could, if they are not unduly costly, undermine the test’s effectiveness. In addition to identifying the these critical implicit assumptions, this Article makes specific recommendations for the Treasury Department and the Service to implement in order to make the substantiality test more theoretically effective in combating the trading of tax attributes.
As discussed below, the substantiality test itself is comprised of two different tests. Part I considers the overall tax effects test, while Part II considers the shifting-transitory tests. Part III concludes.