Taxation of Private Business Firms: Imagining a Future Without Subchapter K

Abstract

Subchapter K is a mess. Its history began with the simple idea that a partnership should be treated for income tax purposes as a conduit, obligated to report its income to the IRS and to allocate this income among its partners but not subject to tax itself. Even when subchapter K was enacted in 1954, Congress recognized that the implementation of this simple ideal would not necessarily be simple. Under the 1954 legislation, each partner's distributive share of each item of income, deduction, or credit was usually determined by the partnership agreement, as it might be modified at anytime before the due date of the partnership's return, but if the agreement for the allocation of any item was infected with a principal purpose to avoid tax, the item had to be allocated in the proportions that the partners shared overall taxable income. Although property could generally be contributed to or distributed from a partnership without causing the partnership or any partner to recognize gain, a distribution was treated as a taxable sale, at least in part, if it altered the partner's proportionate interests in unrealized
receivables or substantially appreciated inventory.
Subchapter K has been amended repeatedly since 1954. Over the last 25 years, nearly every substantial revenue act has contained significant changes to subchapter K. Although these amendments responded to a variety of emerging problems and issues, one theme underlies a large majority of them: The flexibility of the original conduit model facilitated devices to shift income, deductions, and other tax attributes from partner to partner and from property to property in ways that Congress found unacceptable. The original conception of subchapter K-flexibility with some limitations-has thus become encrusted with more and more limitations.