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Friday, September 13, 2024

Weekly SSRN Tax Article Review And Roundup: Kern Reviews Deferring Income With Tiered And Circular Partnerships By Sanchirico & Shuldiner

This week, Adam Kern (San Diego; Google Scholar) reviews an article by Chris William Sanchirico (Penn; Google Scholar) and Reed Shuldiner (Penn), Deferring Income with Tiered and Circular Partnerships.

Adam kern

Taxes can be deferred when partnerships have different taxable years from their partners. A partnership might take account of its income in, say, January, while a partner might only take account of its income in December. In that case, the partner would defer taxes on its distributive share of partnership income for 11 months.

The academic literature has assumed that this opportunity for deferral is limited. In “Deferring Income with Tiered and Circular Partnerships,” Chris Sanchirico and Reed Shuldiner show that it is not. Taxpayers can achieve a large—indeed, unbounded—extent of deferral with tiered and circular partnerships. Moreover, while the partnership structures described by Sanchirico & Shuldiner are ingenious, they are not so large or complex as to be obviously infeasible. This is a genuine opportunity that taxpayers might well seize.

(1) Proof of Concept. The first step in Sanchirico & Shuldiner’s argument is to provide a proof of concept. Sanchirico & Shuldiner describe a (relatively) simple partnership structure that displays how deferral can be extended through tiers of partnerships. The basic mechanism is that relatively short (i.e., less than one year) periods of deferral are tacked on to each other through the structure’s tiers. One tier adds, say, five months; the second tier adds another five months; and so on until taxes are deferred for many years. The simplest structure that uses this mechanism is an inverted pyramid, with each tier composed of more partnerships than the last.

The inverted pyramid, however, has two significant drawbacks. First, the number of partnerships—and of non-partnership partners—required by the structure increases exponentially in the extent of deferral achieved. Second, the inverted pyramid could be shut down with a simple look-through rule that would, in effect, require partnerships to have taxable years that do not differ too greatly from those of their ultimate owners.

(2) More Sophisticated Structures. Sanchirico & Shuldiner then describe two more sophisticated structures that avoid both of those problems. The first is the “truss.” The truss accumulates deferral in much the same way as the inverted pyramid: periods of deferral are tacked on to each other as the partnership adds tiers. But the truss requires far fewer partnerships and non-partnership partners because it reuses partnerships and non-partnership partners within the same tier. The result is something that looks like a lattice, or a truss.

The second structure involves circular partnerships, in an arrangement which Sanchirico & Shuldiner call the “leaky ergodic group.” A circular partnership is an indirect partner of itself. (For example, Partnership A owns partnership B, which owns partnership C, which in turn owns partnership A. A owns itself, via B and C.) The leaky ergodic group is a cluster of circular partnerships, each fractionally owned by non-partnership partners. Because the non-partnership partners own only a small share of each member of the ergodic group, each dollar of income must be passed around the group many times before it is fully “flushed out” to the non-partnership partners. Each additional cycle adds another period of deferral.

Possible Extensions

(1) It would be valuable to estimate the scale of the problem that Sanchirico & Shuldiner identify. Sanchirico & Shuldiner make a convincing case that tiered and circular partnerships enable partnerships to achieve long durations of deferral. But do partnerships use these structures? If so, how many? And how much income do they defer? In order to know whether it is worth bearing costs to shut these structures down, we should want to know how pervasive they are.

Complex partnerships are notoriously difficult to study empirically. But some progress could be made analytically by comparing opportunities for deferral through tiered and circular partnerships to (a) other opportunities for deferral and (b) other opportunities for tax-avoidance in general. These comparisons would help us understand which kinds of taxpayers will find it in their interest to defer income through tiered and circular partnerships.

(2) Another possible extension could consider additional dimensions of partnership complexity. Sanchirico & Shuldiner consider two: the number of partnerships and the number of non-partnership partners. But it seems that other dimensions of complexity could matter as well.

In particular, taxpayers might care about the difficulty of computing the income of partnerships within the structure. This dimension of complexity is not reducible to the sheer number of partnerships within the structure because some partnerships are circular. In the leaky ergodic group, income is passed around many times before it fully leaks to the non-partnership partners. Keeping track of this income could be difficult, and that difficulty could be a significant friction that slows the formation of leaky ergodic groups.

Concluding Thoughts

I have focused on the main contributions of a very rich paper. Along the way to establishing those points, Sanchirico & Shuldiner make several other valuable contributions as well, including two distinct measures of deferral and a precise calculation of the maximum extent of deferral within single-tier partnership structures. Throughout, the argumentation is clear, concise, and rigorous.

We know that sophisticated partnership structures are used to facilitate tax avoidance. But there is much that we do not know about how they are used to accomplish that end. This paper makes several contributions to our understanding of that important issue.

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

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