Partners' Interests in a Partnership

Brad Borden, Washburn Law School

Abstract

Entities taxed as partnerships (e.g., partnerships, limited liability companies, and limited partnerships) have management flexibility and are subject to favorable tax rules. Consequently, such entities are very popular among business owners. Such entities are also complex structures that often present complex tax, legal, and economic issues. The state and tax laws that govern them are intertwined, so actions partners take for legal or economic purposes may affect the partners’ tax consequences. Actions partners take for tax purposes may affect the partners’ economic and legal situations. State and tax laws have related but subtly different concepts that may work in tandem, or at odds, with the partners’ intent. For example, state law focuses on the partnership’s economic items and determines the partners’ economic interests in the partnership. Tax law does not impose a tax on partnership income, so the partners’ legal and economic interests in the partnership should influence the allocation of tax items. Tax law governs the allocation of partnership tax items and generally allows partners to direct the allocation of those items. Tax law uses the partners’ interests in the partnership to test partner-directed tax-item allocations or to otherwise allocate tax items to the partners. Partner-directed tax-item allocations may, however, affect the partners’ economic interests in the partnership. This Article illustrates that state and tax laws are each at work in partnerships but do not adequately correlate the various concepts. Such failure causes ambiguity and may generate unintended negative legal and economic consequences. That ambiguity allows sophisticated business owners to exploit the interaction of the respective laws, and the unintended consequences may ensnare unsuspecting and ill-advised business owners. This Article recommends changes to the law that would correlate state law and tax law, eliminate ambiguity, check the actions of tax game-players, and protect unsophisticated business owners from legal traps.