Passing through? 'Radical' plan would overhaul treatment of partnerships

Congress is debating the biggest rewrite of U.S. partnership rules in 60 years, which may lead to higher taxes for some registered investment advisory firms, real estate and finance businesses -- or prompt them to restructure operations to avoid new costs. The more dramatic of two options from Dave Camp, the top Republican tax writer in Congress, would remove some of the flexibility that has made partnerships attractive legal structures for advisers, real estate investors and hedge funds. He also offered an alternative with lesser changes to simplify some rules and leave the core of the current system in place. The broader proposal surprised tax law specialists, who hadn't anticipated a major policy shift for the 3.2 million U.S. partnerships. The plan may alter existing arrangements by making it more difficult to allocate income and property among partners without triggering tax consequences. Lawyers said they have spent the past week scouring Representative Camp's draft bill, especially his new second option. “Option 2 is radical,” said Blake Rubin, global vice chair of the U.S. and international tax practice at McDermott Will & Emery (1121L) in Washington. “It would be the most significant changes to the partnership tax rules since their enactment in 1954.” Economic Results Real estate investors and hedge fund managers may restructure partnerships to achieve the economic results they get in the current system, perhaps by creating contractual arrangements to replicate what the tax law would prevent. When he released the proposal, Camp said he was seeking to simplify the tax system and make the U.S. tax code more fair. The proposal would change the rules governing what are known as pass-through entities -- businesses such as partnerships that don't pay taxes at the corporate level and instead pass their income through to their owners' individual tax returns. Camp's proposal is a “significant step in the right direction,” said Victor Fleischer, a partnership tax law professor at the University of Colorado in Boulder who has criticized tax maneuvers by private equity funds and other pass- through entities. “Pass-through entities have, increasingly, been used to facilitate aggressive tax gamesmanship,” Fleischer said in an e-mail. “Taxing pass-throughs should be about taxing all income once and only once, not shifting income around to avoid paying any tax at all.” Structural Changes Camp, the chairman of the House Ways and Means Committee, released the draft as part of a plan to overhaul the U.S. tax code. The proposals affecting partnerships are the third in a series of drafts that would make structural changes to long- standing features of the tax code. The first two drafts, if turned into law, would be the most significant rewrite of international tax rules since 1962 and the most fundamental rethinking of taxation of financial products since the modern income tax began in 1913. Camp, a Michigan Republican, hasn't unveiled the rest of his plan, which he wants to advance through his committee this year. He has asked industry groups and others affected by the potential changes to offer comments. “It's potentially a very positive step forward, and it's potentially a very negative step forward depending on how this section would fit in the larger tax reform mosaic of provisions dealing with real estate,” said Jeff DeBoer, president and chief executive officer at the Real Estate Roundtable. The Washington group's board of directors includes executives of Dune Real Estate Partners LP and Hutensky Capital Partners. Partnerships and other pass-through entities have become a popular way to organize businesses in the past 30 years, because of tax-rate reductions for individuals, a double tax on corporate profits and interaction with state legal structures. Business Receipts Such pass-through entities accounted for 38 percent of business receipts in 2007, up from 14 percent in 1980, according to the Congressional Budget Office. Some large businesses are organized as partnerships, including global accounting firms such as Ernst & Young LLP. In 2010, 48 percent of partnerships were in the real estate, rental and leasing industries, according to the Internal Revenue Service. Finance and insurance partnerships reported 48 percent of net income. The draft proposal on pass-through entities presented two options, an incremental set of changes known as Option 1 that have been discussed for several years and the more significant changes called Option 2. Broader Shift The idea behind the broader shift would be to consolidate the rules governing S corporations and partnerships, both types of pass-through entities. The S corporation rules are relatively inflexible, compared with partnership tax law. The law limits the number of shareholders, requires a single class of stock and restricts non-U.S. ownership. The proposal would effectively remove some of those restrictions on S corporations and impose some new limits on partnerships. Simplification would be welcome, though the proposal leans too far toward pushing people into an S corporation structure that growing businesses don't often use, said James Brown, a partner at Willkie, Farr & Gallagher LLP in New York. “The proposal would make partnerships look too much like S corps, with their disadvantages,” he said. The changes could alter longstanding economic arrangements that were created to mesh with the current partnership rules. The transition to a new system, which isn't addressed in Camp's draft, will be important, particularly if the new rules affect existing partnerships, DeBoer said. Transition Rules “I think the transition rules are going to be absolutely impossible,” said Andrea Whiteway, chair of the partnership tax practice at McDermott Will & Emery. “It will be absolutely crazy, and I also think it will be crazy for S corps.” Among the dozens of changes outlined in the draft, tax practitioners are focusing on two areas in which the proposal would limit partnerships' flexibility: special allocation and distribution of appreciated property. Under current tax law, partnerships can split tax benefits and income among partners in myriad ways. For example, in many real estate partnerships, depreciation deductions can be given only to some partners who want to use those breaks to offset other income. Such special allocations reflect the different economic circumstances of multiple properties inside a single partnership and the varying contributions and levels of risk to individual partners, said Karen Burke, a tax law professor at the University of San Diego. 'Economic Reason' “While they can be abused, they do have an economic reason,” she said, suggesting that taxpayers could split apart partnerships and use contracts to replicate what the tax changes might prevent. “If you got rid of special allocations, people would have to recreate them in other ways.” The proposal would limit special allocations only to net ordinary income and losses, net capital income and losses, and tax credits. On distributions, current rules say that it's not a taxable event if a partnership distributes property that has appreciated in value to one of the partners. Taxes are generally triggered only upon sale of the property. The new rule, mimicking the S corporation structure, says that the distribution is a taxable event to the partnership, which would then flow through to all of the partners. Unaddressed Issues The rules leave a number of issues unaddressed, including the tax treatment of private equity managers' carried interest, the law governing real estate investment trusts and potential changes to publicly traded partnerships such as Enterprise Products Partners LP (EPD). Some of the changes being considered are so dramatic that they might have made sense in the abstract, if the tax code were being rewritten from scratch, Rubin said. “It would be nice,” he said, “but it might be so painful getting there that it's just not worth the” effort. --Bloomberg News--