Tax partnerships are useful because no federal income tax is imposed at the entity level, and the income and loss are passed through to the partners. Although the term “partnership” is popular – e.g., “public-private partnerships” and businesses “partnering” with community organizations, generally for tax purposes, an association of persons is a partnership if it is engaged in a joint enterprise with members sharing in the profits and losses of the enterprise, and the association is not treated (by default or election) as a corporation. State law general and limited partnerships and limited liability companies can be taxed as partnerships although they can also elect to be taxed as corporations. The classification of entities formed under foreign law is somewhat more involved, although similarly the default and elective classification rules (including those classifying specified entities as per se corporations) must be consulted.
U.S. partnership tax rules allow flexible allocation of income and loss among partners. For the same reason, the rules contain a myriad of rules designed to prevent inappropriate tax avoidance, centered around the concept that allocations must have “substantial economic effect” to be respected. This means, for example, that a partnership cannot specially allocate income in one year to a partner with expiring NOLs and reverse the allocation (by specially allocating an equal amount of losses) in the second year – this is a prohibited “shifting allocation.” Partnership agreements (or LLC operating agreements) often contain long and multitudinous provisions designed to comply with the substantial economic effect rules while achieving intended business objectives. Experienced legal advisers will work with these complex rules and can build in additional provisions required by the partners such as incentive partnership equity (e.g., restricted partnership/LLC interests similar to restricted stock awards).
Tax audits of partnerships
Another standard article of partnership agreements concerns the provision of information to partners and the designation of a tax matters partner in connection with any tax audits of the partnership. Because a partnership’s income is passed through and taxed to the partners, in designing partnership tax audit rules a choice has to be made whether to assess tax from partnership income items to the relevant partners or to the partnership itself. Generally, partnership tax audit rules in effect since 1982 (referred to as “TEFRA” partnership rules) allow audits to occur at the partnership level but require any consequent taxes to be collected at the partner level. New rules enacted with the Balanced Budget Act of 2015 and coming into effect in 2018 allow the IRS to collect tax at the partnership level, with certain exceptions. The exceptions are important because under the latter approach, current partners may bear tax on income attributable to former partners. The new rules will need to be considered in partnership agreements for both new and existing partnerships.
The partnership tax rules are particularly complex although central concepts can be explained simply enough. And of course, the rules are constantly being revised and supplemented.