In Taxing Selling Partners, Emily Cauble ably details various shortcomings and inconsistencies in the taxation of sales of partnership interests, then proposes a concrete and clear remedy to these myriad problems. Specifically, Cauble examines four scenarios in which the sale of a partnership interest yields a tax result different from the sale of that partnership’s assets. Two of these scenarios draw on longstanding issues involving partner-partnership divergences in holding period and use, while the other two scenarios engage changes in law from December 2017. The first of these changes closes a loophole involving sales of partnership interests by non-U.S. persons—a fix that Cauble argues is incomplete. The other change limits the availability of excess business losses, though, as Cauble notes, not necessarily on transfers of partnership interests. To solve these problems, Cauble advocates aligning the tax consequences of sales of interests and assets by, more or less, looking through to assets when an interest is sold.
The problems identified by Cauble arise from a familiar source. Since 1954, the Internal Revenue Code has approached partnerships as both an agglomeration of partners and an entity separate from those partners. McKee, Nelson & Whitmire describe this duality as a “blending of” aggregate and entity concepts; as Cauble demonstrates, “tension between” also would serve. For sales of partnership interests, the entity concept generally predominates, with exceptions (that is, aggregate treatment) for selling partners’ shares of so-called “hot assets” and certain buying partners’ shares of tax basis in the partnership’s property. Cauble’s normative proposal essentially reverses this relationship, jettisoning the entity concept in favor of something close to pure aggregate treatment. This move is bold, and one that contains much promise for positive reform.
As Cauble acknowledges, her proposal’s detractors are likely to claim complexity in opposing any move away from the entity norm on sales of partnership interests. Cauble convincingly argues that asset valuations and determinations of character should not pose a serious hurdle to her proposal (though the valuations may invite taxpayer game-playing). But, from my perspective, a third source of complexity—the mechanics of allocating hypothetical tax items to partners—may create real headaches, especially for less sophisticated taxpayers and their advisers. Too many partnerships use distribution-driven targeted allocation provisions, which essentially punt the hard labor of allocating of tax items to return preparers, and not enough of these provisions give sufficient guidance on the allocation of character. Furthermore, hypothetical liquidations at fair market value may not accord with book capital accounts—an outcome that parties are willing to chance in order to get the economics right. Should such liquidations be used (or usable) under Cauble’s proposal? If not, let them eat layer cake allocations! Overall, forcing parties to think through these types of issues in advance may be a good thing, but it adds complexity—and costs.
To evaluate the costs of complexity, even if only incremental, a better sense of the problem’s scope and stakes is needed. Cauble argues that current law treats taxpayers in ways that are “both unduly favorable and unduly unfavorable,” depending (somewhat arbitrarily) on those taxpayers’ specific situations. From this perspective, current law deviates from Haig-Simons principles and norms of horizontal equity and should be rectified, full stop. Welfare and efficiency, however, would account more explicitly for costs and benefits, as well as which individuals bear those costs and reap those benefits. These tax policy ends also might be reached through alternative means. If the core problem is lower rates on certain categories of income, then perhaps the capital gains preference should be eliminated (compare to the taxation of qualified dividends at capital gains rates). If non-U.S. persons are not taxed adequately on sales of property, then maybe those rules should be reformed. At the very least, the non-zero costs of Cauble’s proposal indicate that these options should stay on the table—or at least in the conversation, if politics make them infeasible.
Cauble also alludes to the broader problem of legislative “ripple effects,” in which a change to one tax rule implicates changes to a bunch of related tax rules. These subsidiary changes may not be made, given resource constraints and political economy considerations. In effect, Cauble proposes to decouple these interrelationships, at least for sales of partnership interests. The broader application of this principle, however, remains somewhat unclear. One might go further, and work to decouple all substantive areas of the Code from each other (after, of course, defining what constitutes an indivisible unit of tax law). Alternatively, Congress could empower Treasury to make conforming changes that legislators cannot (presumably stirring up many practitioner insurrections in the process). These ripple effects seem like a big deal, and they certainly warrant further exploration.
In conclusion, Cauble’s paper sheds light on an important and technical set of issues in partnership tax. Her reform proposal should spark conversation among academics, policymakers, and practitioners in the field