TaxProf Blog

Paul L. Caron
Dean





Friday, January 12, 2024

Weekly SSRN Tax Article Review And Roundup: Speck Reviews Circular Partnerships By Sanchirico & Shuldiner

This week, Sloan Speck (Colorado; Google Scholar) reviews Chris William Sanchirico (Penn; Google Scholar) & Reed Shuldiner (Penn), Circular Partnerships.

Sloan-speck

The current crisis in partnership tax enforcement is simultaneously well-established and difficult to define. Notwithstanding new tools (such as the centralized partnership audit regime), new funding (principally from the Inflation Reduction Act), and new initiatives (to audit certain very large partnerships using—as is au courant—artificial intelligence), the precise problems with tax partnerships, as deployed by sophisticated taxpayers and their advisors, remain relatively inchoate. In Circular Partnerships, Chris William Sanchirico and Reed Shuldiner deconstruct the emergent political and scholarly narrative surrounding tiered partnership structures with hook interests that may recursively cycle income earned by a parent partnership back through a subsidiary, possibly without end. Sanchirico and Shuldiner conclude that the problem of “trapped income” in partnership cycles, while difficult to untangle, almost certainly is overstated in current debates. Furthermore, Sanchirico and Shuldiner identify compliance issues inherent in circular partnerships, as well as opportunities for reform to more effectively target income that passes through partnership cycles.

One of Sanchirico and Shuldiner’s major interventions is to better specify the contours of partnership circularity discussed in prior literature, particularly Cooper, et al. (2016). Sanchirico and Shuldiner define an “ownership cycle” as the legal relationships through which a partnership is an indirect partner in itself. For example, take A, B, and C, each partnerships for federal income tax purposes. If A is a partner in B, B is a partner in C, and C is a partner in A (and each have other partners as well), then the three partnerships constitute an ownership cycle in which income may flow from C to B to A and back to C. This structural relationship, however, gives little insight into the amount of income involved, or whether any of this income is trapped permanently. The mere fact of circular ownership (and the circular reporting of certain items of income) says little about tax avoidance or abuse. Indeed, many ownership cycles may involve very small economic interests issued for reasons of control or other state-law factors. As Sanchirico and Shuldiner indicate, economists’ findings about partnership income have translated poorly into political sound bites, and the assumptions and ambiguities inherent in large-scale data analysis tend to exaggerate any holes in the tax system.

To address the potential magnitude of underreporting in circular partnerships, Sanchirico and Shuldiner demonstrate that, outside of two well-delineated fact patterns, ownership cycles with nonpartnership partners do not trap income. The intuition behind this finding is relatively straightforward, with considerably more detail in Sanchirico and Shuldiner’s article and its appendix. Nonpartnership partners are, essentially, leaks in an ownership cycle. These leaks siphon off some income each time that income flows through the cycle. At the (infinite) limit, the leak is complete, and all income is allocated to nonpartnership partners, leaving no income trapped. Although this analysis implies “that a partnership can file and furnish a sequence of incremental K-1s of unlimited length” (the stuff of nightmares, to be sure), just a few iterations typically suffice for the income numbers to approach the limit with reasonable accuracy. From this perspective, circular partnerships present a much smaller compliance problem than previously assumed.

There are, of course, wrinkles. Sanchirico and Shuldiner describe “ergodic groups” of partnerships that involve chained allocations of a fixed portion of one or more tax items to each member of an ownership cycle. In the ownership cycle described above, for example, the tax items would move from C to B to A and back to C without diminution at any step. These are the Hotels California of partnership tax: tax items enter the cycle, but they can never leave. There simply is no leakage, and these tax items are trapped. Similarly, for certain partnerships in which nonpartnership partners’ interests vary over time, the amount of income in the partnership cycle may converge to a number greater than zero. In this case, that quantity of income is trapped. These specific factual situations, to the extent they exist in reality, most likely indicate concerted planning rather than organic evolution. And, as elaborated by Sanchirico and Shuldiner, neither situation precludes an administrable assignment of this trapped income to taxpayers.

One additional mechanism for trapped income arises out of Sanchirico and Shuldiner’s arguments. Even in relatively simple ownership cycles, complete reporting of partners’ income requires somewhat heroic compliance efforts within the complex and often-punitive framework of the centralized partnership audit regime. As noted by Sanchirico and Shuldiner, these compliance efforts require significant coordination across partnerships, as well as a fair amount of legal and practical guidance. Even sophisticated partnerships will struggle in this task (and Sanchirico and Shuldiner propose fixes that would ease this process). But, to the extent that partnerships and their return preparers fail to comply completely, ownership cycles will trap income, at least temporarily. These compliance failures—whether intentional or inadvertent—offer a potentially meaningful reason to adopt the reforms proposed by Sanchirico and Shuldiner, rather than, for example, targeting entities that plan into ergodic groups.

As constructed by Sanchirico and Shuldiner, circular partnerships also implicate questions about the sufficiency of the current law and norms surrounding partnership allocations. Sanchirico and Shuldiner explore whether income allocations within ownership cycles have substantial economic effect under the § 704(b) safe harbor (spoiler: probably not, at least in some cases). But the rise of distribution-driven partnership agreements also sheds light on the policy stakes of reforming circular partnerships. By linking income allocations to partners’ residual economic entitlements on an annual basis, targeted allocation schemes—especially those grounded on § 704(b) book capital accounts—may shunt income away from ownership cycles and towards actual taxpayers. More discretionary allocation schemes, which currently are en vogue, may permit the reverse. Regardless, the problem of circular partnerships is inextricable from—and applies unique pressure to—more general questions about partnership allocations that have emerged over recent decades.

Overall, Sanchirico and Shuldiner’s article sheds important light on circular partnerships and the stakes of regulating them. Their analysis should prove crucial to policymakers, economists, and experts in tax law.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2024/01/weekly-ssrn-tax-article-review-and-roundup-speck-reviews-circular-partnerships-by-sanchirico-shuldin.html

Scholarship, Sloan Speck, Tax, Tax Daily, Tax Scholarship, Weekly SSRN Roundup, Weekly Tax Roundup | Permalink