A Win-Win Proposal for Analyzing Profits-Only Partnership Interests

Brad Borden, Washburn Law School

Abstract

The proper tax treatment of profits-only partnership interests is an unsolved aspect of tax law. The problem has manifested itself recently in the debate over the proper tax treatment of carried interests, a subset of profits-only partnership interests. Current law taxes holders of profits-only partnership interests based upon the character of income determined at the partnership level. Therefore, a partner who contributes only services to a partnership may be taxed at favorable long-term capital gains rates. One group of commentators recognizes such treatment as inequitable and recommends that at least a portion of partnership income allocated to holders of profits-only partnership interests should be taxed as compensation. To obtain the desired compensation result, commentators and lawmakers generally propose disaggregating partnerships (i.e., changing the character of income as it flows from the partnership to service-providing partners). Partnership disaggregation threatens the partnership tax regime, finds little support in partnership tax policy, and potentially disrupts the application of other tax law provisions. The Article suggests that a better method for analyzing profits-only partnership interests is disregarding partnerships that do not come within a policy-based definition of tax partnership. Many arrangements that purport to be tax partnerships do not, or should not, come within the federal definition of tax partnership. The existing definition of tax partnership is, however, antiquated, so some arrangements may fall within the definition, even though policy does not support taxing them as partnerships. Intellectual resources should begin to focus on determining whether a purported arrangement should be disregarded and developing a policy-based definition of tax partnership that would better regulate the application of the partnership tax rules. Analytical methods that properly define tax partnerships will prevent nonpartners from converting compensation income to capital gain and resolve problems raised by carried interests. Partnership disregard will also help preserve the integrity of partnership tax law, creating a win-win solution to an otherwise divisive tax problem.