MauledAgain

Earlier this year, in Getting Smart About Tax Questions, I criticized Marilyn vos Savant, allegedly the world’s smartest woman, about some errors she made in her response to a question about the taxation of egg donors.

This time, Vos Savant took on a question about selling an encumbered residence. The questioner described a situation in which two people owned a home, presumably equally. The home is worth $200,000 “with $10,000 in equity.” Owner #1 will retain title to the house, and offers Owner #2 $5,000. Owner #2 wants $100,000. The questioner asked, “What’s the fairest thing to do?”

It is unclear from the question whether Owner #2 will remain liable on the mortgage loan, or whether Owner #1 will assume responsibility for repaying the loan. Vos Savant did not take that factor into account. Instead, she pointed out that a “key factor” to consider was the amount remaining on the loan. She suggested that, “Maybe the house was bought when it was worth half as much. Or twice as much!” She then presented two examples. In the first, she hypothecates that the house was purchased for $150,000, with $140,000 “left on the loan.” Thus, she concludes that the co-owners “would gain $60,000” if they sold the house for $200,000, requiring Owner #1 to pay $30,000 to Owner #2. In the second example, she hypothecates that the house was purchased for $250,000, with $240,000 remaining on the loan. She concludes that the co-owners would lose $40,000 if they sold the house for $200,000, requiring Owner #2 to pay $20,000 to Owner #1.

Here’s the problem. The facts presented by the questioner make it clear that the balance on the loan – whether the unpaid portion of the loan taken out at the time of the purchase or a subsequent loan, or a combination – is $190,000. The house is worth $200,000, the equity is $10,000, and thus the loan balance is $190,000. The loan balance is not $140,000, and the loan balance is not $240,000. Thus, the examples Vos Savant provides don’t answer the question. They answer questions not asked about situations not confronting the questioner.

Here is the answer that I would have provided. If Owner #1, with the consent of the lender, assumes full responsibility for the loan, Owner #2 should be paid $5,000 by Owner #1. That is the value of Owner #2’s interest in the residence. If, on the other hand, Owner #2 is required by the creditor to remain liable on the loan, then Owner #1 should pay $5,000 to Owner #2, plus any amounts paid by Owner #2 to the lender should be reimbursed by Owner #1 because Owner #1 is taking full ownership of the residence.

To demonstrate why this is correct, consider several possibilities of how the owners ended up in this situation. Assume that they purchased the residence for $200,000, each paying $5,000 in cash, and together borrowing the $190,000. Assume further that the residence did not change in value. Owner #2 invested $5,000, and would be getting that $5,000 from Owner #1, and thus is whole. Or suppose that they purchased the residence for $100,000, each paying $5,000 in cash, and together borrowing $90,000. Assume further that the residence increased in value to $200,000, and that the owners jointly borrowed another $100,000 and split the proceeds. Economically, the owners together have a gain of $100,000, the residence having been purchased for $100,000 and having increased in value to $200,000, and thus each owner should emerge from the transaction with their $55,000, the sum of the $5,000 that was originally invested plus $50,000, one-half of the gain. If Owner #1 pays $5,000 to Owner #2, Owner #2 ends up with $55,000, with $50,000 coming from the proceeds of the second mortgage loan and $5,000 coming from Owner #1.

No matter how one slices it or how many factual variations are constructed – of course, without changing the original facts that at the present time the equity is $10,000 and the loan balance is $190,000 – Owner #2 would incur a windfall if paid $100,000 by Owner #1. There are no factual variations – putting aside gifts from Owner #1 to Owner #2, something beyond the scope of the question – that justifies Owner #2 walking away with $100,000, or $30,000, or that justifies Owner #2 paying anything to Owner #1.

I concluded Getting Smart About Tax Questions with this comment, “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to income taxation, she has more to learn.” I conclude this post with “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to residential financing, she has more to learn.”

Several years ago, in Are Private Tolls More Efficient Than Public Tolls?, I described why it is wrong to put public assets into the hands of private sector entrepreneurs so that they can enrich themselves at public expense, and how attempts in the distant past and the recent past to provide travel access through private highways failed. I explained, citing earlier posts, how privatization of public highways works for the entrepreneur only by disadvantaging the public. Aside from raising tolls, the entrepreneurs play all sorts of political games to force motorists to use their highways, such as “persuading” legislators to enact laws lowering the speed limits on public highways, adding unnecessary traffic lights and stop signs, and forbidding the widening of, or other improvements to, public highway alternatives to the privatized toll road.

About a year ago, in When Privatization Fails: Yet Another Example, I explored the adverse consequences of putting a public bridge into private hands in Michigan. Earlier this year, in How Privatization Works: It Fails the Taxpayers and Benefits the Private Sector, I examined a similar failure, though with parking garages and not highways or bridges. Two months ago, in More Proof of How Privatization Harms Taxpayers, I explained how privatization of the tax refund process in Virginia did more harm than good.

Last month, I had the opportunity to see privatization, United Kingdom style, and privatization, France style. The difference in terms of highway conditions was notable, and as I drove I thought about the difference. In the United Kingdom, motorways for the most part are congested, even at times one would expect that not to be the case. During my ten days of driving, I often encountered stopped or crawling traffic in remote areas. Service areas exist, though in some places they are few and far between. Residents with whom I discussed the motorway situation complained that they expected to get more for their road tax dollars than they were getting. In contrast, motorways in France are congested for the most part only at the times and places one would expect. They are in such good condition that the speed limit is roughly 10 miles per hour higher than in the United Kingdom. Rest areas exist every ten kilometers or so, and service areas every 40 kilometers. Given the choice of which system I would want to use for a road trip, setting aside issues of destination and weather, I would select France.

I noticed two differences. First, in the United Kingdom, only a very small fraction of the motorway system is in the hands of the private sector. Second, the tolls in France, though high by American standards, are lower per-mile than the tolls charged on the few miles of United Kingdom motorways. An peek at what happened in the United Kingdom opens the door to understanding the differences. Because of severe congestion on one motorway, the United Kingdom government decided that a bypass needed to be constructed. Rather than building it with road tax funds, the government granted the construction rights to a private company that was permitted to charge tolls. What happened? The road was built, but the motorists didn’t show up. Motorists continued to use the severely congested motorway. Because of the insufficient revenue, the private company increased the tolls several times, and consequently road usage declined even more. I drove the toll road, out of curiosity and because my routing sent me that way. For a one-time use, I wasn’t very concerned about the toll. There was very little traffic on the toll road, and when it reconnected with the motorway it bypassed, traffic slowed to a crawl.

If privatization is going to work, it needs to be structured so that the public, through government representation, has overall control of the system. Tolls need to be imposed so that the alternatives, such as French regional roads, are sufficiently less attractive in comparison that most motorists will use the motorways. Toll revenue needs to be plowed back into the highways and not diverted to other uses such as has happened in Pennsylvania and other states. The bottom line is that the notion of driving on highways without paying tolls or any sort of sufficient fuels tax is a recipe for the deficiencies afflicting American interstate highways. Because the problem isn’t limited to interstates, but afflicts all sorts of roads, the solution is the mileage-based user fee, an approach that I have discussed extensively, in posts such as Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, Change, Tax, Mileage-Based Road Fees, and Secrecy, Pennsylvania State Gasoline Tax Increase: The Last Hurrah?, Making Progress with Mileage-Based Road Fees, Mileage-Based Road Fees Gain More Traction, Looking More Closely at Mileage-Based Road Fees, The Mileage-Based Road Fee Lives On, Is the Mileage-Based Road Fee So Terrible?, Defending the Mileage-Based Road Fee, and Liquid Fuels Tax Increases on the Table.

Though some Americans perceive France as the antithesis of the capitalistic ideal, its experience with motorways suggests that there are ways to rescue America from the highway infrastructure deterioration that threatens its economy and security, without selling out to the private sector. The history of highway privatization failures in the United States and in the United Kingdom suggests that there are some lessons to be learned in those nations.

The definition in section 753 of income in respect of a decedent refers only to section 736(a) payments. If section 736 is repealed, section 753, as presently structured, becomes meaningless. Section 753 does not define income in respect of a decedent, because there are other payments made in respect of a decedent partner that constitute income in respect of a decedent. Even if section 736 is not repealed, it makes no sense to characterize 736(a) payments as income in respect of a decedent. The portion of section 736(a) payments that would be characterized as income in respect of a decedent under the general income in respect of a decedent rules would remain so characterized. Any other portion of section 736(a) payments ought not be characterized as income in respect of a decedent. Thus, no matter what is done with respect to section 736, section 753 ought to be repealed.

If section 736 is the most criticized provision in subchapter K, the anti-abuse regulations might be the most criticized regulations under subchapter K. The criticism extends not only to the substance of the regulations but also to the authority of the Treasury to issue them. With the enactment of the section 7701(o) economic substance provision, the need for the anti-abuse regulations is even less than whatever it may have been at the outset. In just about every ruling and judicial decision in which the anti-abuse regulations were invoked as a reason for the conclusion, alternative grounds under other provisions also were set forth. Repeal of the anti-abuse regulations would be an improvement.

Section 708 provides that a partnership terminates for federal income tax purposes if “within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.” The consequences of a termination of a partnership by reason of sale of a partnership interest are for all intents and purposes negligible. Because of the seven-year time periods in sections 704(c)(1)(B) and 737, the regulations were amended to provide that the terminated partnership transfers its assets to a new partnership, which is an impossibility because the new partnership cannot have just the old partnership as a sole partner. The old partnership is then treated as transferring the interests in the new partnership to the new group of partners, another impossibility because the old partnership cannot have multiple interests in the new partnership. The new partnership ends up with the same assets, adjusted bases in its assets, and other attributes as were held by the old partnership. Considering that large partnerships that qualify for the special rules in sections 771 through 777 do not terminate on account of sales of interests, there is no need to terminate any partnership on account of sales of interests, and particularly no need to engage in a sequence of impossible transactions that amounts to nothing more than a charade that in effect keeps the terminated partnership, for all intents and purposes, in existence.

Section 736 is one of the most frequently criticized provisions in subchapter K. Proposals for its repeal have been in place for decades. It is difficult to get across to students the fact that section 736 does not provide for substantive outcomes but merely separates liquidating distribution payments into segments, each of which is subject to different provisions elsewhere in subchapter K. The regulations under section 736 provide rules to deal with liquidating distribution payments received over multiple years, but those situations ought to be subjected to the provisions applicable to installment sales.

Considering the extensive explanations provided by advocates of repealing section 736, there is no need to duplicate those efforts. Suffice it to say that section 736 is a maze of exceptions, exceptions to exceptions, and exceptions to exceptions to exceptions, is a trap for the unwary who do not realize there are opportunities to affect the outcomes by putting goodwill provisions into the partnership agreement, and adds layers of unnecessary complexity to the taxation of partnerships.

The provisions in section 724 that retain the character of gain or loss in unrealized receivables, inventory, and depreciated capital assets contributed to a partnership, and the provisions in section 735 that retain the character of gain or loss in unrealized receivables and inventory distributed by a partnership, apply not only to those items but also, under section 724(d)(3) and section 735(c)(2) to substituted basis property. In other words, if the partnership or partner exchanges the property and the adjusted basis in the replacement property reflects in whole or in part the adjusted basis in the exchanged property, sections 724 and 735(a) apply to the replacement property.

In contrast, if the partnership or partner transfers the property to another person under circumstances that cause the other person to obtain a transferred basis in the property, sections 724 and 735(a) do not apply. In other words, if a partner, for example, transfers distributed inventory by gift to a another person, the other person holds the property as an investment and subsequently disposes of the property within the five-year property, section 735(a)(2) does not apply. The other person’s gain would be capital gain, not ordinary income. For sections 724 and 735(a) to be fully effective, they need to apply not only to substituted basis property but also to transferees with transferred basis in the property.

Sections 724(a) and (b) and 735(a)(1) and (2) apply to retain the original character of not only the inherent gain or loss in property contributed to, or distributed from, a partnership, but also any gain or loss arising from changes in value after the contribution or distribution. In contrast, section 724(c) applies to retain the original character only of the inherent capital loss in a capital asset contributed to a partnership. That approach makes more sense in light of the purpose of these provisions, which is to prevent manipulation of the character of the inherent gain or loss. Gain or loss arising after the contribution or distribution does not exist at the time of the transaction and thus is not something in the hands of the partner or partnership to attempt to recharacterized. In other words, the reasoning behind the limitation in section 724(c) should apply to sections 724(a) and (b), 735(a)(1) and (2), and the proposed section 735(a)(3).

Section 735(a)(1) provides that unrealized receivables distributed by a partnership to a partner generate ordinary income when the partner sells them, even if held by the partner as an investment, no matter when the sale takes place. Section 735(a)(2) provides that inventory distributed by a partnership to a partner generates ordinary income when the partner sells it, even if held by the partner as an investment, if sold within five years of the distribution.

Section 724(a) provides that unrealized receivables contributed by a partner to a partnership generate ordinary income when the partnership sells them, even if held by the partnership as an investment, no matter when the sale takes place. Section 724(b) provides that inventory contributed by a partner to a partnership generates ordinary income when the partnership sells it, even if held by the partnership as an investment, if sold within five years of the distribution. Section 724(c) provides that a capital asset contributed by a partner to a partnership that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partnership sells it, even if held by the partnership as inventory, if sold within five years of the distribution.

It is easy to see the lack of symmetry. There is no section 724(c) equivalent in section 724(a). The reason probably is explained by the fact that section 724 was enacted decades after section 735 was enacted and nothing was done to bring section 735 up to date. There needs to be a section 724(a)(3), to provide that a capital asset distributed by a partnership to a partner that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partner sells it, even if held by the partner as inventory, if sold within five years of the distribution.

One of the most vexing aspects of subchapter K is the complexity of the optional and special basis adjustments under sections 732(d), 734(b), and 743(b). The complexity arises not only from the extensive computational requirements but also from the fact that the optional basis adjustments generally are just that, optional, though mandatory in certain instances. Accordingly, section 732(d) provides a special basis adjustment that stands in place of the section 743(b) optional basis adjustment, but not the section 734(b) optional basis adjustment, but only in certain situations and not in all situations to which the section 743(b) adjustment would apply.

The basis adjustments under sections 734(b) and 743(b) resolve problems that exist because of the manner in which subchapter K applies both entity and aggregate approaches to different provisions. Those problems affect all partnerships. Now that pencil and paper calculations have been replaced by computer software, there is no good reason to make those adjustments optional. If making them mandatory in certain situations is acceptable, making them mandatory across the board is no less justifiable. If the adjustments are mandatory, the need for section 732 disappears and it can be repealed.

Section 751 is a subchapter K provision designed to ensure that gain or loss attributable to ordinary income assets in a partnership is characterized as ordinary income or loss, whether the gain is triggered by a sale of a partnership interest or a distribution from the partnership. Under section 751(c), unrealized receivables and a long list of recapture items are classified as ordinary income items. Under section 751(d), partnership inventory items are classified as ordinary income items if the transaction is a sale of a partnership interest, but if the transaction is a distribution the inventory items are classified as ordinary income items only if they are substantially appreciated in value. Substantial appreciation exists if the value of the inventory items exceeds 120 percent of their adjusted basis.

Until 1997, inventory items were classified as ordinary income items, for purposes of both sale and distribution transactions, only if they were substantially appreciated. In 1997, the definition of ordinary income items was amended so that inventory items are treated as ordinary income items for sale transactions but are not treated as ordinary income items for distribution purposes unless they are substantially appreciated.

Finding a sensible reason for the change, and for the different treatment, is difficult if not impossible. I tell students that Congress has created a trap for the unwary. I also tell students that Congress has also created an examination question that indicates the extent to which students are paying attention, being precise, and recognizing the twists and turns of tax law. Making matters worse, unrealized receivables are treated as inventory items, the practical effect of which is that because they already are ordinary income items, they play a role in determining whether inventory is substantially appreciated. It works both ways. For example, inventory with an adjusted basis of $100 and a value of $105 is not substantially appreciated standing alone, but if the partnership also has unrealized receivables with an adjusted basis of zero and a value of $50, the inventory is substantially appreciated because the total adjusted basis is $100 and the total value is $155. As another example, inventory with an adjusted basis of $100 and a value of $130 is substantially appreciated standing alone, but if the partnership also has realized receivables with an adjusted basis and a value of $100, the inventory is not substantially appreciated because the total adjusted basis is $200 and the total value is $230.

This complexity is unwarranted and unnecessary. Inventory is an ordinary income asset, period. Whether or not it is substantially appreciated is irrelevant to its nature as an ordinary income asset. Congress should repeal the substantial appreciation test and treat all inventory as ordinary income assets for purposes of section 751, whether the transaction is a sale of a partnership interest or a distribution.

The extent to which guaranteed payments affect adjusted basis in a partnership interest is unclear. This is yet another question for which there is no authority found in the statute, regulations, administrative issuances, or judicial decisions.

A partner must include a guaranteed payment in gross income in the taxable year for which the partnership properly claims the deduction or makes the required increase in the basis of an asset. Thus, if the partnership uses the accrual method and the partner uses the cash method, the partner includes the guaranteed payment in gross income even if it has not been paid. A mechanism is required to prevent the partner from including the guaranteed payment in gross income when it is eventually paid. This mechanism is basis.

The question is whether the basis acquired by reason of including the guaranteed payment in gross income is a stand-alone basis in the guaranteed payment or is added to the partner’s adjusted basis in the partnership interest. Though one might expect something to be found in section 705 or even section 707(c), or the regulations interpreting those sections, there is no answer there or in revenue rulings, notices, or court opinions. There is dictum in one case suggesting that the partner increases adjusted basis in the partnership interest, but there are inferences in the regulations that the partner does not increase adjusted basis in the partnership interest, though the reasoning is quite attenuated.

An example illustrates why the question matters. Assume that at the beginning of year 5, A’s adjusted basis in the partnership interest is $100. During year 5, the partnership accrues a $400 guaranteed payment to A but does not pay it. After deducting the guaranteed payment, the partnership breaks even, so there are no partnership items to allocate among the partners. During year 6, the partnership again breaks even, but there is no guaranteed payment. During year 6, the partnership sells a capital asset in which its adjusted basis is $1,000. It sells the asset for $1,000, and distributes $200 to each partner, including A. During year 7, the partnership again breaks even, and again there is no guaranteed payment, but the partnership pays to A the $400 guaranteed payment accrued during year 5.

If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the results are as follows. The basis of A’s partnership interest at the end of year 5 is $500 ($100 plus $400). The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to $300 ($500 minus $200). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($400 minus $100).

If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in an item that could be called, for ease of reference, guaranteed payment receivable, the results are as follows. The basis of A’s partnership interest at the end of year 5 remains $100, and A also has a basis of $400 in the guaranteed payment receivable. The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($200 minus $100). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the guaranteed payment receivable to zero, but does not generate any gain.

The difference, therefore, essentially is one of timing. Either way, A must report ordinary income of $400 in year one, and gain of $100. If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the gain is reported in year 7. If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in a guaranteed payment receivable, the gain is reported in year 6. Put another way, the issue is whether the basis obtained from including the guaranteed payment in gross income can be used to offset distributions and not just payment of the guaranteed payment.

However the question is resolved, clarifying amendments to the Internal Revenue Code or the regulations are necessary. Even if the situation arises only for partners with zero or relatively low adjusted basis in their partnership interests, taxpayers deserve an answer.

Section 704(e)(2), which attempts to apply two assignment of income doctrines to partnerships, is difficult to read, challenging to explain, and questionable in its application. Section 704(e)(2) is designed to prevent a partner who provides services on behalf of a partnership from shifting the income generated by those services to other partners who received their partnership interests by gift or who are family members. It also is designed to prevent a partner who provides capital to a partnership from shifting the income generated by that capital to other partners who received their partnership interests by gift or who are family members.

There are better ways to accomplish what section 704(e)(2) is designed to accomplish. In addition, the principles of section 704(e)(2) ought to apply across the board, and not merely in the limited circumstances to which it applies. Unlike sections 704(c) and 737, which also deal with assignment of income concerns but do not have subchapter S equivalents, section 704(e)(2) has a subchapter S equivalent, so this aspect of assignment of income apparently is of greater concern to the Congress.

With section 704(b) having been amended and regulations issued under section 704(b) in the years after section 704(e)(2) was enacted, it makes more sense to incorporate the concerns of section 704(e)(2) in section 704(b). In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that needs to be taken into account. The repeal of section 704(e)(2), and its accompanying section 704(e)(3), needs to be done in tandem with the enactment of language in section 704(b) that states, “In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that must be taken into account.”

In determining whether a partnership exists, it is necessary to identify at least two partners. The question of whether a individual or entity is a partner is wrapped up in the question of whether a partnership exists. These questions are factual in nature. Though the “check the box” regulations provide some rules, ultimately the initial question is whether an entity exists that ultimately can be classified as a partnership. In light of these regulations and the questions that must be answered, one is left wondering why section 704(e)(1) continues to exist.

Section 704(e)(1) provides that “a person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor. . .” Section 704(e)(1) was enacted in response to the Supreme Court’s decision in Culbertson, which essentially tagged the question of whether a person is a partner as a factual question. To the extent section 704(e)(1) was intended to reduce the amount of factual analysis necessary to answer the question, it has failed. First, it only applies to certain partnerships, and is of no value for partnerships in which capital is not a material income-producing factor. Second, section 704(e)(1) takes one factual question, namely, does the person in question intend to be a partner, and turns it into two questions, namely, when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

The process of determining whether a partnership exists should also determine who the partners are. This is true even if two persons are identified as partners and the status of a third person is in question. The reason is that the technical question is whether a partnership exists among all three persons, not whether the third person is a member of a partnership between the first two persons.

In any event, no matter how the issue of whether a person is a partner is resolved, section 704(e)(1) is of no help whatsoever. Its repeal not only would remove useless language from the Internal Revenue Code, it would eliminate the need to answer the two questions of when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.

One of the more complicated areas of Partnership Taxation is the treatment of contributed property. Sections 704(c) and 737 are challenging, not only in terms of language, but also in terms of application and computations. These provisions are necessary to the extent it is necessary to prevent gain or loss inherent in property contributed by one partner from being shifted to other partners. But how necessary is that goal? The answer can be found by looking at S corporations.

If an S corporation shareholder contributes appreciated or depreciated property to the S corporation, the gain or loss recognized by the corporation, which includes the gain or loss inherent in the property when contributed, is allocated among all the shareholders. Thus, the inherent gain or loss is shifted to other shareholders. Why is there no section 704(c) and section 737 equivalents in subchapter S? Apparently, preventing the shifting of the gain or loss isn’t as terribly important as one might have guessed. The practical explanation probably is that enacting section 704(c) and section 737 equivalents in subchapter S would make subchapter S “too complicated.” So why is it acceptable to have a “too complicated” subchapter K when it comes to contributed property?

Until and unless subchapter S is graced with section 704(c) and section 737 equivalents, subchapter K ought to be relieved of a computational and interpretational complexity that does not afflict subchapter S. Surely the shifting of income and loss either is good or bad, but whatever it is, it ought to be the same whether it is being done by partners or by subchapter S shareholders.

For students who think that tax law is nothing more than a set of rules that they need to memorize, I emphasize that there are numerous situations in which not only must the rules be applied to a variety of different factual situations but also situations in which the rules are not known and advice to clients must be based on a careful analysis using comparative application of other provisions. One such example in the subchapter K area is illustrated by the following question. Is a loss carryforward under section 704(d) available to a transferee of the partnership interest? Those unfamiliar with tax, and even those somewhat familiar with tax, are likely to conclude that the answer is in the Code, the regulations, an administrative issuance, or a court decision. But in this instance they would be in for a surprise. There is no authority providing an answer to that question.

When I taught Partnership Taxation, I did not try to provide the students with an answer to the question of whether a section 704(d) loss carryforward is available to the transferee of a partnership interest, though some students reacted negatively to the lack of a definite answer. Instead, I encouraged them to look at other provisions in the tax law that deal with the transfer of losses, an approach which also bothered some students who considered forays outside of subchapter K to be “irrelevant” to the course. I pointed out to them that there are provisions that prohibit or discourage the transfer of losses. I also pointed out to them that there are provisions that permit the transfer of losses. Finally, I directed them to examine the language of section 1366(d)(2)(A), which provides that the corresponding S corporation loss carryover is available “with respect to that shareholder,” referring to the shareholder who owned the stock when the loss pass-through was disallowed.

So why, I asked and continue to ask, does the language “with respect to that partner” not appear in section 704(d)? Should its absence be interpreted as an intent by Congress to permit the 704(d) loss carryforward to be available to the transferee? There are canons of statutory construction that would permit that conclusion. From a policy perspective, is there any reason to treat section 704(d) losses and section 1366(d) losses differently when it comes to the treatment of the transferee? I use this issue to demonstrate the difference between the issue of what the law should be and the issue of what the law is as demonstrated by the question of what one tells the client.

The answer to this one is easy. Section 704(d) and section 1366(d) loss carryforwards, in terms of availability to the transferee, must be treated in the same manner. Preferably, section 704(d) should be amended to include the language “with respect to that partner.”

The language of section 705, which provides for the computation of a partner’s adjusted basis in a partnership interest, is unwieldy and requires inefficient calculations. Section 705 provides that basis equals basis reflecting the contribution of money or property and basis reflecting purchase price, increased “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years of” taxable income, tax-exempt income, and excess depletion, and decreased by distributions and “by the sum of [the partner’s] distributive share for the taxable year and prior taxable years” of losses and non-deductible expenditures not chargeable to capital account.

For example, consider X, who contributed $100 to a partnership at the beginning of year 1. X’s distributive share of the partnership’s taxable income for year 1 is $50, for year 2 is $60, for year 3 is $30, and for year 4 is $80. There are no other partnership items and no distributions. Following the statute, X’s adjusted basis at the end of year 1 is $150 ($100 plus $50). Following the statute, X’s adjusted basis at the end of year 2 is $210 ($100 plus $50 plus $60). Following the statute, X’s adjusted basis at the end of year 3 is $240 ($100 plus $50 plus $60 plus $30). Following the statute, X’s adjusted basis at the end of year 4 is $320 ($100 plus $50 plus $60 plus $30 plus $80). This example, of course, is too simple. Imagine what the computation looks like in the fifteenth or twentieth year, and imagine, as likely is the case, that there are items of tax-exempt income, losses, distributions, and non-deductible items not chargeable to capital account.

What happens in practice, of course, is that practitioners begin with adjusted basis as of the end of the previous year, and then add the items for the current year to compute adjusted basis as of the end of the current year. Thus, in the example, X’s adjusted basis at the end of year 3 would be computed by adding $30 to $210.

Is it possible to rewrite section 705 to reflect practical reality? Of course. The model already exists. Section 1367, which provides for the computation of a shareholder’s adjusted basis in S corporation stock, provides that basis “shall be increased for any period by the sum of [the various items] determined with respect to that shareholder for such period.” Section 1367 is a newer provision than section 705 and reflects advances in technical drafting that took place during the intervening years. There is no good reason not to clean up section 705 so that it parallels section 1367.

For as long as I had been teaching Partnership Taxation, students have asked why section 707(b) exists. The question is not why the substantive rules of section 707(b) exist, as the answer to that question is simply to prevent abuses in terms of characterization and loss shifting. The question is why not simply make sections 267(a)(1) and 1239 applicable to partnerships. In fact, section 1239 does apply to partnerships and thus, in some ways, duplicates section 707(b).

My guess is that those drafting the original subchapter K worked in isolation and did not view subchapter K as part of a larger tapestry. Even to this day, it is not uncommon to observe proposed tax legislation, and even enacted tax legislation, that demonstrates a lack of cohesion with other provisions in the tax law. Granted, my suggestion would not change the law, and thus would not simplify tax compliance and practice, but it would make the Internal Revenue Code shorter and more concise. Every little bit helps.

Under sections 771 through 777, certain partnerships with 100 or more partners are permitted to elect simplified treatment for computing taxable income, for reducing the number of separately stated items, and for combining items that would be separately stated under the generally applicable subchapter K provisions. From a technical perspective, these special provisions distort partners’ income and loss because they circumvent the limitations and other restrictions that would apply at the partner level.

The justification for these provisions is simplification of what would otherwise be complicated computations for these large partnerships. Yet partnerships with fewer than 100 partners are not relieved of these computational complexities and challenges. It is odd that the large partnerships, in a better position to afford the professional assistance or software to do the computations, are afforded relief unavailable to smaller partnerships generally not in quite the same position to afford the tax preparation help.

These special provisions were added sixteen years ago, before tax preparation software had evolved into the relatively sophisticated programs that are now available. If a partnership with 97 partners is required to comply with sections 702 and 703, there is no reason that a partnership with 103 partners ought not be in the same position.

There are two possible solutions to this disparate treatment. One is to repeal the special provisions. The other is to make them available to all partnerships. Technically, the better solution is to repeal the special provisions. That is what I would advocate. The existing caste system for partnerships is simply wrong.

The treatment of charitable contributions as not part of a partnership’s taxable income under section 703(a)(2)(C) adds unnecessary complexity to the process of determining distributive shares. The only possible justification for excluding charitable contributions from taxable income is the fact that the deductibility of charitable contributions by the partners depends on each partner’s particular adjusted gross income and other charitable contribution transactions. Yet the same can be said for items such as capital gains and losses and section 1231 gains and losses, but those items are not kept out of the computation of taxable income.

Separating the charitable contribution deduction from the computation of taxable income also adds complexity to the computation of the partner’s adjusted basis in the partnership interest. Rather than being included in the increase on account of taxable income, charitable contributions must be taken into account separately under section 705.

There is no reason not to leave charitable contribution deductions as part of taxable income, just as the capital loss deduction is part of taxable income. The separate statement of items requiring particularized treatment by partners is sufficient to preserve the character and other attributes of charitable contributions in the same way it preserves the character and other attributes of capital losses, and the other hundreds of items that require separate statement treatment.

A simple repeal of section 703(a)(2)(C) solves the problem. Section 702(a)(7) and the regulations under section 702 already contain language that would require the separate statement of the charitable contribution deduction.