TREATMENT OF PARTNERS AND PARTNERSHIPS

Arthur Willis

Subchapter K of the 1954 Internal Revenue Code deals quite comprehensively with the income taxation of partners and partnerships. In subchapter K for the first time an effort was made to set forth in the statute the working rules for the determination of the income tax consequences of various transactions involving the partnership and the partners.

Subchapter K is frequently criticized as being too complex. In fairness, it must be admitted that upon first examination the provisions do appear involved. Some of the complexities are resolved when the total concept and the basic policies are understood.

COMPLEXITIES ARISING FROM SPECIAL TAX TREATMENT OF VARIOUS ITEMS

One of the major reasons for the complexities in applying the income tax law to partners and partnerships is the complex nature of the present income tax provisions with respect to special tax treatment of various classes of income, gain, loss, deduction, or credit. The partnership is a taxreporting but not a taxpaying entity for income tax purposes. The tax payable on partnership income is paid by its members, each of whom reports in his tax return his distributive share of partnership income. If the partnership realizes a type of income, gain, loss, or deduction that is subject to special treatment for income tax purposes, it is necessary to preserve the amount of each such item in a separate classification so that each partner will report in his tax return his proportionate share of that particular item.

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The statute specifies nine classes of income, gain, loss, deduction, or credit which are required to be separately stated by the partners and the partnership.1 However, one of the statutorily specified classifications consists of any class of income or deduction that the Secretary or his delegate requires by regulations to be separately stated.2 The regulations specify 12 additional classes of income, gain, loss, and deductions as to which each partner must report his distributive share. The partnership of course must likewise show in its partnership return these 12 additional categories of items of income and deduction. Furthermore, the regulations provide for a separate statement by the partner of his distributive share of any item of partnership income or deduction that would affect the income tax liability of the partner if he did not report that item separately. Thus, the theoretical number of classes of items that the partnership may be required to report separately, and as to which each partner is required to separately report his share, could range to infinity.

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1 Secs. 702(a) and 703 (a) (1), Internal Revenue Code of 1954.

2 Sec. 702 (a) (8), Internal Revenue Code of 1954.

3 Regulations, sec. 1.702-1 (a) (8) (i).

4 Ibid.

Since the average partnership is small, as a practical matter most partnerships will not have numerous categories of income or deduction to report. In many instances, there will be only one category consisting of the partnership's ordinary income or loss arising from regular business operations. However, the possibility of having to report numerous categories of income and deduction items is a complicating factor in the partnership return form and in the application of the income tax statute to partners and partnerships.

The partnership provisions, like a mirror, accurately reflect the complexities of the income tax laws in its application to individual and corporate taxpayers. If the general income tax concepts were substantially revised so as to eliminate the tax significance of many different categories of income or deduction items, the application of the income tax law to partners and partnerships would be correspondingly simplified.

THE CAPITAL GAIN PROBLEM

The problem of preferential tax treatment given to income derived from capital gains is a complicating factor in the entire field of income tax law. In the area of partnerships it is necessary to have rather complicated provisions in order to insure against the use of partnerships as a device for the conversion of ordinary income into capital gain. Historically this has arisen primarily through a sale of a partnership interest or the sale by all of the partners of their interests in the partnership. Prior to the adoption of the Internal Revenue Code of 1954, the courts generally held that the gain on sale of a partnership interest was a capital gain, even though the gain was attributable to partnership inventory or to other partnership assets which would have resulted in ordinary income to the partnership had it sold such assets. Section 751 of the 1954 code attempts to plug this loophole with quite complex provisions dealing with the gain from sale of an interest in a partnership having unrealized receivables or substantially appreciated inventory. Section 751 also deals with distributions by a partnership having either unrealized receivables or substantially appreciated inventory.

Should the Congress take action to eliminate the special treatment given to capital gains, the provisions of subchapter K could be simplified by the deletion of the complex "collapsible partnership" pro

visions.

ELECTIONS AVAILABLE TO PARTNERS

Another complicating factor in the area of taxation of partners and partnerships lies in the various courses available to the partners with respect to the tax treatment of certain transactions. For example, it is left to the discretion of the partners whether, for income tax purposes, the difference between the tax basis and the fair market value of contributed property shall be allocated among all of the partners in proportion to their interests in partnership profits or losses, or shall be allocated solely to the contributing partner. An

5 See decisions cited in G.C.M. 26, 379, 1950-1 Cum, Bull., p. 58, a ruling in which the Commissioner of Internal Revenue conceded that with respect to pre-1954 code cases the gain on sale of a partnership interest would be taxable as capital gain in cases not involving sham transactions.

• Sec. 704 (c) (1), Internal Revenue Code of 1954. 7 Sec. 704 (c) (2), Internal Revenue Code of 1954.

other significant provision in this area of election by the partners arises in the payments under section 736 to a retiring partner or to the successor in interest of a deceased partner. Section 736 gives the partners considerable latitude as to whether the payments to a retiring partner or to the successor in interest of a deceased partner are to be considered as made entirely for his interest in partnership property or whether a portion of such payments is to be treated as a distribution of partnership income.

It is believed that the granting of choices of tax consequences in certain partnership transactions is desirable even though it obviously creates some complexity in the statutory framework. The partnership exists by an agreement among the partners. So long as there is no significant tax avoidance, it would appear desirable to permit the partners to agree among themselves regarding tax consequences of certain transactions involving the partnership and the partners.