Profits-Only Partnership Interests

Abstract

Profits-only partnership interests grant service-providing partners an interest in the profits of a partnership but not its capital. Such interests are a proverbial double-edged sword: they create economic arrangements needed in business, but provide opportunities for inequitable tax reductions. Business participants make economic decisions to use profits-only partnership interests to reduce agency costs and appropriable rents. The current law, however, empowers business participants to form partnerships that are equivalent to employment arrangements and use profits-only partnership interests to obtain long-term capital gains. Thus, with no economic consequences, they convert ordinary income (taxed at up to thirty-five percent) to long-term capital gain (taxed at fifteen percent). Commentators and lawmakers generally propose partnership disaggregation to eliminate the inequity. Partnership disaggregation changes the character of income (from capital gain to ordinary income) as it flows from the partnership to service-providing partners. It may enhance equity, but it ignores the nature of tax partnerships, threatens the partnership tax regime, and has other negative side effects. The Article suggests that partnership disregard is a better way to address the inequity profits-only partnership interests cause. Partnership disregard uses economic concepts to identify the policy-relevant differences between tax partnerships and disregarded arrangements, such as employment arrangements, leases, and loans. Partnership disregard distinguishes arrangements that should qualify for partnership tax treatment and those that should not. It eliminates inequity while preserving the integrity of partnership tax regime and other areas of the law.

Keywords: profits-only partnership interest, section 707(a)(2), carried interest, compensation

JEL Classification: D20, D21, D23, D31, D63, H21, H22, H24, H25, H26, J33, K34, M52