FLORIDA TAX REVIEW
VOLUME 4 1999 NUMBER 3

The Future Taxation of Private Business Firms
George K Yin'

I. INTRODUCTION ................................ 144
II. THE NEED TO REEXAMINE CURRENT LAW ............ 144
U. TAXATION OF PRIVATE FIRMS AS CONDUITS ............ 150

A. The Basic Case for Conduit Taxation ........... 151
B. The Fundamental Difficulty of Conduit Taxation

and the Case for Entity Taxation ............... 153
1. Economic Effect ..................... 156
2. Substantiality ....................... 160
3. Subjective Purpose ................... 162
4. Would Some Other Test Be Effective? ..... 163
5. Summary .......................... 164

C. Which Approach Would Be More Administrable? ... 165
D. Summary and Conclusion .................... 171

IV. A SMIPLIFIED VERSION OF CONDUIT TAXATION ........ 172
A. Introduction ............................. 172
B. Eligibility for the Simplified Version:

Theory and Definition ...................... 174
1. Ownership Limitations ................ 176

a. Individuals as Owners ........... 176
b. Public Subchapter C Firms

as Owners ................... 182
c. Other Possible Owners .......... 185

* Harrison Foundation Research Professor of Law, University of Virginia. Copyright
© 1998 by George K. Yin. This article represents a continuation of work I have done as
reporter to the American Law Institute's Federal Income Tax Project on the Taxation of
Private Business Enterprises. Portions of this article have been drawn from drafts and
discussions undertaken in connection with that project as well as from a prior article, George
K. Yim, The Taxation of Private Business Enterprises: Some Policy Questions Stimulated by
the "Check-the-Box" Regulations, 51 SMU Law Rev. 125 (1997). None of the views expressed
here should be attributed to the ALL to my co-reporter, Professor David Shakow, or to any
of the consultants to the project. I am greatly indebted to Professor Shakow for his close and
continuing collaboration on the project and his assistance in preparing this article. All errors
are mine alone. This article was prepared for presentation at a February 1998 symposium and
research for it was completed in May 1998. A final ALI Reporters' Study is scheduled to be
published in June 1999.



Florida Tax Review

d. Summary .................... 190
2. Only One Class of Residual Ownership

Interests .......................... 190
3. Other Eligibility Conditions Not Proposed .. 194

a. Number of Owners ............. 195
b. Ownership of Other Entities ....... 196
c. Nature of Income .............. 196
d. Size of Enterprise (Measured by

Assets, Sales, Income or
Some Other Measure) ........... 199

C. Operating Rule Provisions of the Simplified
System ................................. 202
1. Explicitly Elective System .............. 202
2. Passthrough Scheme; Allocations of Tax

Items and Debt of the Firm ............. 203
a. In General ................... 203
b. Preferred Interests ............. 205
c. Losses ...................... 206
d. SPBF Liabilities ............... 207

3. Contributions and Distributions .......... 211
a. Contributions-Present Law ....... 211
b. Distributions-Present Law ....... 213
c. Additional Partnership Rules to

Prevent Income Shifting, Income
Character Changes, and Timing
Distortions ................... 214
i. Section 704(c)(1)(A) ....... 214
ii. Reverse Section 704(c)

Allocations ............. 216
iii. Section 704(c)(1)(B) ....... 216
iv. Section 737 ............. 216
v. Section 707(a)(2)(B) ...... 217
vi. Section 731(c) ........... 217
vii. Sections 724, 735,

and 751(b) ............. 217
viii. Subjective Purpose ........ 218

d. Analysis of Current Law ......... 218
i. Entity Versus Aggregate

Theory of the Firm ....... 221
ii. Tax Policy Considerations .. 223

e. Summary and Proposals ......... 226
i. Contributions ........... 227

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The Future Taxation of Private Business Firms

ii. No Section 704(c)(1)(A)
Rule .................. 228

iii. Distributions ............ 229
iv. Other Rules Not Included ... 233
v. Relation to Default

Conduit System .......... 234
4. Treatment of Ordinary Income Assets

of an SPBF .............................. 234
a. Sections 751 and 341 Not Included in

the SPBF Rules ..................... 234
b. Character Continuation Rules ........... 238

5. Inside Basis Adjustments .................... 238
a. In General ........................ 238
b. Adjustments Made on Distributions of

Property .......................... 239
c. Adjustments Made on the Sale of

Ownership Interests .................. 240
6. Conversions/Reorganizations of Firms From

One System to Another ..................... 242
a. Private Firm (Either SPBF or Default

System) to Public Firm (Subchapter C) ..... 242
b. Public Firm (Subchapter C) to Private Firm

(Either SPBF or Default System) ......... 244
c. Changing Tax Systems of Private Firms

(SPBF to Default System or Vice-Versa) .... 245
7. Transitional Considerations .................. 246

V. SUMMARY AND CONCLUSION ...................... 247

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I. INTRODUCTION

Recent federal and state law developments liberalizing the permissible
forms of business organizations and the classification of such organizations
for tax purposes have underscored the need to reexamine the current system
of taxing the income of private businesses. This article, which undertakes that
reexamination, makes two principal claims. First, current law ought to be
replaced by a system whereby all private business firms, no matter what their
form of organization and organizational characteristics, are taxed as conduits
for income tax purposes. Second, because conduit taxation is so complicated,
the system should be implemented through a "two-track" approach in which
a subset of private business firms would, at their election, be subject to a
simplified set of tax rules. In general, the simplified version would be
available to firms which have only individuals as owners and which have
surrendered some flexibility in their economic dealings.

Part II of this article briefly explains why current law merits
reexamination and Parts III and IV correspond to the two main claims being
made. A final part contains a brief summary and conclusion.

II. THE NEED TO REEXAMINE CURRENT LAW

Thanks to a recent change adopted by the Treasury Department
responding to important developments at the state level regarding the
permissible forms of business organization, many private business firms, no
matter what their organizational characteristics under state law, are provided
with an explicit choice regarding how the income of the firm is taxed.' For
firms engaged in general business activities, the choices under current law are
generally the rules contained in subchapters C, K, and S of the Internal
Revenue Code. Although incorporated firms are currently not provided with
the same choice as unincorporated ones, an unincorporated business with
precisely the same characteristics as an incorporated firm is given that choice.
Hence, it seems only a matter of time before all private firms, incorporated
and unincorporated, will be afforded the same explicit choice of taxation
schemes.

1. See Regs. §§ 301.7701-1, -2, and -3. The new regulations, which were effective
January 1, 1997, were stimulated by state law changes permitting partnerships and other
unincorporated organizations to possess business characteristics traditionally associated with
corporations. See Notice 95-14, 1995-1 C.B. 297; Rod Garcia & Nancy Loube, LLCs, or How
the Government Got to Check-the-Box Classification, 67 Tax Notes 1139 (1995).

2. Public firms are not provided the same choice by reason of § 7704 of the Code.
See Regs. § 301.7701-2(b)(7). The proper classification and taxation of public firms is beyond
the scope of this article.

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The Future Taxation of Private Business Firms

This state of affairs is a curious one, given the historical background
and substantive rules of subchapters C, K, and S. The origin of subchapters
C and K and, specifically, the separate entity taxation of corporations as
opposed to the conduit taxation of partnerships, can be traced to some extent
to a debate which raged during the last part of the 19th Century and the early
part of the 20th Century concerning the nature of corporate and partnership
personality.3 At that time, the "aggregate" versus "entity" controversy,
familiar now in the partnership area, applied to both corporations and
partnerships. Gradually, the entity theory prevailed for corporations but not
for partnerships:

Corporate characteristics of free transferability of interests, continuity
of life, limited liability and centralized management... emphasized
the distinction between the corporation and its shareholders. Corpo-
rate liability was not shareholder liability. The life of the corporation
was independent of that of its shareholders.... This was in contrast
to a partner's relationship to a partnership. Partners were generally
actively involved in the partnership's business, as well as responsible
for the partnership debts. Additionally, the life of the partnership was
contingent on the life of its members. These factors created a unity
between the partner and the partnership. Legal theory, following these
basic differences between a corporation and a partnership, veered
toward a natural entity theory in the corporate area, but resisted it, at
least partially, in the partnership area.

This theory of business organization personality influenced the
income tax rules that developed for those organizations. The first income
taxes in this country, imposed during the Civil War period, were generally
only taxes on individuals. Although certain companies were required to pay
tax on amounts paid out as dividends or interest, the same amounts were then
deductible from the payee's tax base.' Thus, the original structure could well
be viewed as imposing a mere withholding tax on the companies and not a

3. See Marjorie E. Kornhauser, Corporate Regulation and the Origins of the
Corporate Income Tax, 66 Ind. U. 53, 57-62 (1990). Much of the following discussion
regarding the origins of the corporate income tax are based on Professor Kornhauser's article.

4. See id. at 61.
5. See Act of July 1, 1862, cli 119, §§ 81-82, 90-91, 12 Stat. 432,469-71,473-74

(1862). The taxes were also imposed based upon the specific industry or trade of the business
and not its form of organization.

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Florida Tax Review

tax independent of the individual income tax.' For owners of other firms,
both incorporated and unincorporated, a pure conduit approach was specified:

In estimating the annual gains, profits, or income of any person,...
the gains and profits of all companies, whether incorporated or
partnership, other than the companies specified in this section, shall
be included in estimating the annual gains, profits, or income of any
person entitled to the same, whether divided or otherwise.7

Thus, as of the time of the Civil War period, there was no clear indication
that corporations should be treated any different from partnerships for income
tax purposes.

This attitude changed in 1894 when the income tax was reintro-
duced.8 The 1894 law contained both a 2% tax on the income of individuals
and a similar tax on the income of all "corporations, companies, or associa-
tions ... but not including partnerships."9 An individual, however, was
entitled to exclude from his or her tax base any dividends received from a
corporation which had already paid the 2% tax.'0 This feature, combined
with the fact that both taxes were levied at the same rate, also suggested that
the corporate tax might be viewed as a mere withholding tax. However, in at
least one important respect, the corporate tax was more clearly a separate and
independent tax: unlike individuals, who only had to pay tax on income in
excess of $4,000, corporations were not provided with any exemption
amount." Thus, the corporate tax was not simply a convenient and admin-
istrable way to collect the individual income tax on corporate-source income.

The significance of the separate, entity tax levied on corporations in
1894 was not lost on the legislators at the time. Those who advocated a
corporate exemption similar to the one available to individuals objected to the
fact that corporate-source income would otherwise be taxed more harshly than
the income of partnerships. They viewed the corporation as primarily an
aggregate of individuals analogous to a partnership. In contrast, legislators

6. The Supreme Court was confused regarding the nature of the tax imposed on
certain companies, first holding that it was a separate tax, Barnes v. The Railroads, 84 U.S.
294, 303 (1872), and then concluding that it was a mere withholding tax and therefore part of
the individual income tax system, United States v. Railroad Co., 84 U.S. 322 (1872).

7. Act of June 30, 1864, ch. 173, § 117, 13 Stat. 223, 281-82 (1864).
8. See Patrick E. Hobbs, Entity Classification: The One Hundred-Year Debate, 44

Cath. U. L. Rev. 437, 438 (1995) ("[the 1894 Act ... marked the first time in this country's
revenue history that the law distinguished corporations from other types of business
organizations for tax purposes").

9. Act of Aug. 27, 1894, ch. 349, §§ 27, 32, 28 Stat. 509, 553, 556 (1894).
10. See id. § 28, at 554.
11. See id. §§ 27, 32, at 553, 556.

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The Future Taxation of Private Business Firms

who successfully opposed all attempts to adopt a corporate exemption,
including some amendments limiting an exemption to small corporations,
supported their position by articulating an entity theory for corporations.'2

Consistent with the statute and legislative background, the regulations issued
by the Treasury under the 1894 Act made clear that the corporate tax did not
apply to partnerships. Instead, partnership income would be taxed under a
conduit system:

Partnerships, as such, are not liable to taxation of firm or partnership
profits or income, but each individual member of the partnership
shall include his share of the partnership profits, gains, or income, in
his individual list, where he is required by law to make return of his
income for taxation.'3

The 1894 income tax was later found to be unconstitutional in
Pollock v. Farmers Loan and Trust Co.'4 Nevertheless, the divergent tax
treatment of corporations and partnerships, based in part on the differing
theories of their legal personality, was established. The corporate excise tax
of 1909, the predecessor to the modem corporate income tax, imposed a 1%
tax on net income in excess of $5,000." Because of constitutional and other
reasons, the tax was explicitly limited to corporations and associations;
individuals and partnerships engaged in the same business were not subject
to the tax. 6 Once again, one of the justifications for this treatment was the
"entity" nature of a corporation. 17 Following passage of the Sixteenth
Amendment, subsequent tax acts continued the pattern of taxing corporations
but not partnerships as separate entities. The only difference was that with the
reintroduction of an individual income tax in 1913, Congress provided for
various schemes to implement at least partial integration of the corporate and
individual income taxes. Integration efforts were eventually ended in 1936.

12. See Kornhauser, supra note 3, at 87-90. There was also concern that
corporations, but apparently not other forms of business organizations, were not paying their
proper share of taxes. See Hobbs, supra note 8, at 445-46.

13. Regulations Relative to the Assessment, Levy and Collection of the Tax on
Incomes Under the Provisions of the Act of Congress in Effect August 28, 1894 (December
13, 1894), reproduced in Roger Foster & Everett V. Abbot, A Treatise on the Federal Income
Tax Under the Act of 1894 484 (1895).

14. 157 U.S. 429 (1895), reh'g granted, 158 U.S. 601 (1895).
15. Act of Aug. 5, 1909, cl. 6, § 38, 36 Stat. 11, 112 (1909).
16. See id. Pollock had placed into question whether this pre-Sixteenth Amendment

tax would be constitutional if applied to individuals. Another reason for limiting the tax to
corporations was a desire to regulate businesses organized in corporate form. See Kornhauser.
supra note 3, at 99.

17. See Kornhauser, supra note 3, at 102-05.

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In summary, the separate entity taxation scheme of subchapter C and
the conduit taxation approach of subchapter K can be traced to some extent
to theories relating to the legal personality of corporations and partnerships.
Corporations, as entities, were taxed independently from owners; partnerships,
as aggregates, were not. And important in deciding whether a business
organization constitutes an entity or an aggregate were the characteristics of
the organization such as centralized management, continuous life, free
transferability of ownership interest, and limited liability.

Other differences in the substantive rules of subchapters C and K bear
out this entity/aggregate distinction. For example, contributions to and
distributions from a corporation are more likely to be taxable than those to
and from a partnership." These results naturally flow from a conception of
a corporation, but not a partnership, as an entity separate and distinct from
its owners. Similarly, liabilities incurred by a partnership, but not a corpora-
tion, are passed through and taken into account in determining the tax
consequences of the owners of the firm. 9

Subchapter S, enacted in 1958 and substantially revised in 1982,
constitutes a middle ground between subchapters C and K. It provides a
conduit form of taxation for certain businesses organized in corporate
form.2" Nevertheless, perhaps because of its close relationship to subchapter
C (a given business may move easily between the C world and the S world)
and because it has been applicable only to corporations, subchapter S retains
many "entity" tax characteristics. Probably the most important is the refusal
to permit corporate-level debt to pass through to the shareholders of an S
corporation for income tax purposes.2' In addition, the contribution and
distribution rules for S corporations follow the subchapter C provisions more
closely than their subchapter K counterparts.22 Furthermore, unlike the
section 754 election in subchapter K, there is no mechanism in subchapter S
for adjusting the inside basis of a firm's assets upon the death of an owner,
a transfer of ownership interests, or a distribution from the firm. Finally, S
corporations, but not subchapter K firms, can participate in a tax-free
reorganization with a C corporation.3

18. Compare IRC § 351 with § 721 and §§ 301, 302, 331, 311, and 336 with
§§ 731, 704(c)(1)(B), and 737.

19. See IRC § 752.
20. Former subchapter R, enacted in 1954 and repealed in 1966, did the opposite

of subchapter S. It allowed certain unincorporated businesses to elect to be taxed as entities
under subchapter C.

21. See IRC § 1366(d).
22. See IRC §§ 351, 311, 336, 1368, 302, and 331.
23. See IRC § 1371(a).

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The Future Taxation of Private Business Firms

Thus, each set of rules-most clearly in the case of subchapters C
and K and less obviously in the case of subchapter S-was designed to apply
to a particular business organization form with specific characteristics. Yet,
adoption of the check-the-box regulations reflects a policy determination
generally to disregard business organization form and characteristics for
income tax purposes. Given that, it is difficult to understand why firms are
nevertheless allowed a choice regarding how they are taxed and why they are
given the particular choices that they are.

If the three sets of rules produced more or less the same tax
consequences in most situations, the choice among them might not be
especially significant. But that is not the case. In any given situation,
subchapters C, K or S might provide an advantageous tax result for particular
taxpayers. For example, subchapter C generally offers graduated tax rates for
the business income of firms subject to those rules,24 and there are a host
of special tax provisions limited to subchapter C firms.rn Subchapter K
offers the purest form of conduit taxation under which the firm is not taxed
and business income and losses are passed through to the owners of the firm.
Finally, as just noted, subchapter S offers another form of conduit taxation
which, nevertheless, incorporates certain significant entity tax characteristics.
As a result, subchapter S is in many cases less advantageous than subchapter
K but in certain cases, more advantageous.6

The elective tax treatment of private firms under current law
undermines both equity and efficiency objectives for the income tax.
Although in theory, similarly situated businesses have the same opportunity
to be treated in the same tax-advantageous manner under current law, the
practical reality is probably to the contrary, due to disparities in the quality

24. See IRC § 11(b). If the shareholder tax of a subchapter C firm is deferred or
reduced sufficiently or eliminated altogether, the graduated rate structure can mean that
business income is taxed more favorably under subchapter C than under either subchapters K
or S. Subchapter C may also be an attractive choice for those private firms which envision
going public someday. Cf. Joseph Bankman, The Structure of Silicon Valley Start-Ups, 41
UCLA L. Rev. 1737, 1749-50 (1994).

25. See, e.g., IRC §§ 465(a)(1)(B) and 469(a)(2)(B) (at risk and passive activity loss
rules generally applicable only to certain closely held C corporations). On the other hand, these
rules do apply to the individuals who are either partners or S corporation shareholders. See
IRC §§ 465(a)(1)(A) and 469(a)(2)(A).

26. In addition to the differences previously noted in the text, there are two other
significant ways subchapters K and S depart from one another. Subchapter K but not
subchapter S firms may specially allocate their tax items among their owners. Compare IRC
§ 704(a) and (b) with IRC § 1377(a). On the other hand, there exists in subchapter K a series
of complicated rules designed to prevent tax advantages in selected situations. See, e.g., IRC
§§ 704(c), 707(a)(2) and (b), 724, 731(c), 735, 737, and 751. Subchapter S corporations are
not subject to those rules although they are subject to the collapsible corporation provisions
of § 341. See IRC § 1371(a).

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Florida Tax Review

of advice the businesses receive. By permitting such disparate choices without
any apparent underlying conceptual foundation, current law has simply
provided a tax benefit for the well-advised and a trap for the ill-advised.
There is no particular policy reason why the taxation of private business fimis
should result in the minimization of tax liabilities for only the well-
advised.27 Moreover, current law violates vertical equity norms. By giving
business owners a range of tax liabilities to choose from, current law by
definition cannot impose the "proper" level of tax on them based upon
vertical equity principles.

Inefficiency arises because of the increased transactions costs
necessitated by current law. To minimize tax burdens, businesses must be
prepared to examine the consequences of three possible operating rule
structures on their anticipated business activities and to comply with the rules
selected. The IRS must administer and give oversight to the three different
structures. Further, the planning, compliance, and administration costs are
ongoing in that businesses may have the opportunity to change their choice
of rule structure as their business activities evolve. Moreover, aside from
increasing transactions costs, current law's favorable tax treatment of private
business firms distorts economic decisions for those businesses on the
individual/firm and public firm/private firm boundaries, thereby potentially
causing deadweight losses. Finally, to the extent simplification is a tax policy
goal independent of equity and efficiency concerns, it is certainly not
enhanced by current law.

In conclusion, the current system of taxing the income of private
business firms has evolved into one which is inconsistent with its historical
roots and violates important tax policy objectives. The balance of this article
describes an alternative system for such taxation.

III. TAXATION OF PRIVATE FIRMS AS CONDUITS

A threshold question is whether a private firm should be treated as
a "conduit" or an "entity" for tax purposes. Under conduit taxation, the firm
is not treated as a taxpayer separate and apart from its owners. Rather, the
firm is transparent for tax purposes; its various tax items pass through to the
owners of the firm, the real (and only) taxpayers in interest. Under current
law, the purest form of conduit taxation is found in the partnership tax rules
of subchapter K.

27. See William A. Klein & Eric M. Zolt, Business Form, Limited Liability, and
Tax Regimes: Lurching Toward a Coherent Outcome?, 66 U. Colo. L. Rev. 1001, 1012-13
(1995).

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The Future Taxation of Private Business Finns

In contrast, under entity taxation, the firm is treated as a taxable
entity in its own right. Although entity taxation is often associated with the
"double tax" system of subchapter C, it need not have that consequence. For
example, in 1992, the Treasury Department recommended exploration of an
approach, termed the Comprehensive Business Income Tax (CBIT), which
would subject the income of all business entities (except for extremely small
ones in terms of gross receipts), including sole proprietorships, partnerships,
corporations, and firms organized in other business forms, to a single,
comprehensive entity-level tax, with generally no further income tax
consequences at the owner level.2 Other, similar proposals have been
advanced over the years.29 The Treasury estimated that CBIT would produce
greater welfare gains than any other form of corporate integration, including
Treasury's version of partnership-style integration. 3

The following sections explore some of the pros and cons of conduit
and entity taxation.' Although the choice is a close one, the conclusion is
that all private firms should be taxed in accordance with a conduit approach.

A. The Basic Case for Conduit Taxation

The most basic form of business is the sole proprietorship. Sole
proprietors have historically been taxed directly on their proprietorship
income as it arises and been entitled to deduct currently any losses of the
enterprise as they arise. The business itself has not been subject to a separate
federal income tax. It would theoretically be possible to treat a proprietorship
as a taxpayer separate from its proprietor, but such a system would be very
problematic, depending upon the applicable tax rate structure. For example,
if all proprietorships were treated as taxpayers subject to a flat 30% income
tax rate, then individuals in marginal tax brackets higher than 30% might be
encouraged to redesign their economic arrangements to generate proprietor-
ship income for themselves rather than wages or other income. 2 Meanwhile,

28. U.S. Dep't of Treasury, Integration of the Individual and Corporate Tax
Systems: Taxing Business Income Once (1992) [hereinafter Treasury Integration Report].

29. See Mortimer M. Caplin, Income Tax Pressures on the Form of Business
Organization: Is It Time for a "Doing Business" Tax?, 47 Va. L. Rev. 249, 261 (1961)
(suggesting adoption of an entity-level tax on the profits of virtually all business enterprises,
whether incorporated or not, combined with a lowering of dividend taxes to alleviate concerns
of double taxation).

30. See Treasury Integration Report, supra note 28, at 134 (Table 13.8). 139-141.
31. A third option is a hybrid approach in which low-rate taxes at both the firm and

owner levels equate to a single tax on business income. See George K. Yin, Corporate Tax
Integration and the Search for the Pragmatic Ideal, 47 Tax L Rev. 431, 480-501 (1992).

32. This discussion ignores the potentially significant effect of employment and state
and local taxes on the choice of compensation arrangement.

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Florida Tax Review

proprietors in marginal tax brackets less than 30% might be encouraged to
employ the opposite strategy. For instance, they might increase the level of
deductible salary payments paid by their proprietorship to themselves. Given
the absence of arm's length dealing in a proprietorship, it would presumably
be extremely difficult for the IRS to monitor and prevent purely tax-
motivated arrangements of this sort.

Taxing the proprietorship's income in a progressive manner would
not improve matters because there still would not be any necessary correla-
tion between the proprietorship's tax rate and the proprietor's ability to pay.
The proprietor may well have income or losses from other sources. It is for
this same reason that the graduated tax rate structure under which many
corporations are taxed today does not carry out any vertical equity objec-
tive.33

Assuming proprietors are to continue to be taxed directly on their
business income and losses, then it follows that businesses with more than
one owner should likewise be taxed as conduits. If the proprietorship is not
treated as a separate taxpayer, it is difficult to see why, say, a two-person
general partnership should be so treated. Further analogies then might suggest
that no business firm should be separately taxed. As an economic matter, if
proprietors are taxed directly on their proprietorship income but partnerships
(and not the partners) are taxed on the partnership income, then the tax
system will have created an undesirable barrier against or inducement in favor
of the pooling of resources via a partnership.

True, the state law characteristics of a proprietorship may be different
from those of many other business forms. Unlike a proprietorship, other
forms of business organization are treated for an increasing number of state
law purposes as legal entities separate from their owners. For example, the
recently Revised Uniform Partnership Act (RUPA) generally endorses an
entity theory of a partnership, and it therefore provides that the withdrawal
of a partner from a partnership causes the dissolution of the partnership only
in limited circumstances? 4 RUPA also makes clearer that a partner is not

33. See IRC § l(b).
34. See Revised Unif. Partnership Act § 801 (amended 1996), 6 U.L.A. 87 (Supp.

1997) [hereinafter RUPA]. See, generally, RUPA, § 201 ("[a] partnership is an entity distinct
from its partners"), comment to § 201 ("RUPA embraces the entity theory of the partnership").
As of the end of 1995, seven states had adopted the RUPA. Although the Uniform Partnership
Act (UPA) included certain entity-type characteristics for partnerships, particularly relating to
the rights of the entity to own and convey property (see U.P.A., §§ 8, 10, 25, and 26), the Act
generally favored an aggregate interpretation of the partnership. Examples of the UPA's
aggregate approach included its provisions relating to the joint and several liability of partners
for partnership debts, the rights of all partners to manage and conduct the business of the
partnership, and the dissolution of a partnership upon any partner's ceasing to be associated
with the business, See U.P.A., §§ 15, 18(e), and 29.

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The Future Taxation of Private Business Firms

co-owner of the underlying property of the partnership; rather, the only
transferable interest of a partner in the partnership is the right to share in
profits and losses and to receive distributions.' Other forms of doing
business, such as limited partnerships, LLCs, limited liability partnerships
(LLPs), limited liability limited partnerships (LLLPs), and of course,
corporations, justify an entity interpretation of the business because, among
other things, they generally insulate the owners from the entity's liabilities.
Further, the check-the-box regulations may accelerate these state law trends,
with future approval by the states of noncorporate business forms having
more and more entity characteristics.

But the clear message of the check-the-box regulations is that state
law differences among private business entities should be ignored in deciding
how they are taxed.36 Thus, the decision of whether a private firm should
be taxed like a conduit or an entity should seemingly be based on tax policy
considerations such as equity, efficiency, and simplicity. As just discussed,
the strongest tax policy argument in favor of the conduit approach is that
people pay taxes, not entities, and that people should pay income taxes in
accordance with their abilities to pay. The use of an entity to generate income
should not interfere with that basic objective. Hence, the entity should be
disregarded for tax purposes and the income of the entity should be taxed
directly to its owners. Entity losses and other tax items should similarly be
passed through directly to the owners, to be netted with the owners' items
from other sources. Another tax policy argument favoring the conduit
approach is that it avoids distorting the choice of business form, given how
proprietorships are taxed.

But these arguments may only be valid for a theoretically ideal form
of conduit taxation. For reasons detailed in the next section, if a conduit
approach is considered in actual practice, it may be that the approach does
not accomplish either tax policy objective very well while, at the same time,
spawning significant transactions costs.

B. The Fundamental Difficulty of Conduit Taxation and the Case for Entity
Taxation

The same theoretical reasons in support of conduit taxation would
lead one to conclude that entity taxation is unacceptable. For example, if we
take as a given that people and not entities pay taxes, and that people should
pay income taxes in accordance with their ability to pay, then it would seem

35. See RUPA, supra note 34, §§ 501, 502.
36. Cf. William A. Klein, Income Taxation and Legal Entities, 20 UCLA L Rev.

13, 15 (1972) (argued that correlation between taxation method and relationship under state
law of an entity to its owner has "relatively limited explanatory value").

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Florida Tax Review

odd and inconsistent with those premises to impose a separate income tax on
the business entity itself. If the owners of the firm indirectly bear the burden
of the entity-level income tax, then the proper rate for the tax should
presumably be tied to their ability to pay. But how should the entity tax rate
be determined where the ability to pay of the owners is different from one
another?

The case for entity taxation, however, is essentially a negative one.
Specifically, if it is not possible to design a workable conduit tax system
which is broadly applicable to most private business firms and is consistent
with general income tax principles, then an entity tax approach may be worth
a second look. To illustrate some of the difficulties in implementing conduit
taxation, the balance of the discussion in this part II of the article will focus
mainly on the partnership tax rules-subchapter K-because they represent
the most refined example of conduit taxation in existence.

Under conduit taxation, if a business firm earns $300 in taxable
profits in a given year, a total of $300 of taxable income must be currently
included in the tax base of the owners of the firm. But how much should be
included in whose base? The difficulty in answering that question is the
fundamental problem of any conduit system.

The source of the difficulty is the fact that income and other items
realized by many business entities are treated under state law as belonging to
the entity and not to the owners. The receipt by the owners of the entity's
income, for example, may arise only upon a distribution from the entity. Yet
consistent with basic income tax principles, tax reporting of the income
cannot await a distribution. Someone must include it in that person's tax base
when the income arises. Thus, if there is no distribution of the income by the
entity, there must nevertheless be a current allocation of the income among
the owners to permit them to report currently their share of it.

How is the allocation of income and other items determined for tax
purposes under current law? In general, current law permits the allocation of
tax items to be made with great flexibility. Indeed, the general rule for a
partnership allows the determination to be made by the partners in their
partnership agreement.37 Hence, by private agreement, the partners might
decide to allocate the income of the partnership equally among themselves,
or to allocate all of the income to only one partner, or to provide for any
other sharing arrangement. Assuming the allocation has "substantial economic
effect," a concept discussed below, the only limitation is that all of the
partnership taxable income must be reported by some partner or partners for
the year. The partners also may allocate to themselves different shares of each
partnership tax item in any given year and may vary the allocation of each

37. See IRC § 704(a).

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The Future Taxation of Private Business Finns

such item from year to year. The tax sharing rules are flexible to permit
consistency with flexible economic sharing arrangements. Indeed, the tax
shares can even be determined with hindsight, that is, after the end of the
year in question, to accommodate the often hindsight determinations of
economic shares.

But flexible tax sharing rules also may be used simply to minimize
the collective tax liabilities of the partners, to the detriment of the Treasury
and all other taxpayers. By allocating items to the partner who is in a position
to utilize them most favorably for tax purposes, the partners can put their
respective tax advantages to best use and share in the resulting tax savings.
As Professor Surrey and others stated with some concern when special
allocations were first permitted in 1954:

... parties, perhaps for the first time in the history of the tax laws,
will be permitted to agree on the incidence of tax; to agree as to
which of several co-earners of income shall be entitled to specific
items of income and of income tax deduction and credits. Capital
gains could be allocated on one basis, dividends on another, tax-free
interest in accordance with still another ratio. By agreement,
operating expenses, depletion or depreciation could all be allocated
in differing proportions.

The ability to contract with respect to specific items of
income, and particularly with respect to specific items of deduction
and credit, would give the ingenious businessman and his lawyers the
utmost flexibility in devising a variety of novel and unique business
arrangements.38

Is there anything wrong with the partners minimizing their collective
tax liabilities in that manner? The objection, often unstated, is the concern
that the partnership vehicle permits the taxpayer to obtain a tax result more
favorable than the one that would have arisen had the taxpayer simply owned
a share of the business's assets directly.39 Thus, assume a taxpayer would
have had $100 of taxable income from a share of certain real estate assets
had the taxpayer owned that share directly. Assume that with $100 of income
for the year from the asset, a portion of the taxpayer's net operating loss

38. See J. Paul Jackson, Mark H. Johnson, Stanley S. Surrey, Carolyn K. Tenen &
William C. Warren, The Internal Revenue Code of 1954: Partnerships, 54 Colun. L Rev.
1183, 1187-88 (1954).

39. Cf. Regs. § 1.701-2(c)(1) (potential applicability of partnership anti-abuse
regulation if "[t]he present value of the partners' aggregate federal tax liability is substantially
less than had the partners owned the partnership's assets and conducted the partnership's
activities directly").

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Florida Tax Review

carryover would have expired unused. To preserve the integrity of the taxable
unit, the tax laws presumably should not permit the taxpayer to join up with
two others, obtain a special $300 allocation of taxable income for the year
(representing the taxpayer's share of income from the asset and the shares of
the taxpayer's partners), offset it with a disproportionately small allocation of
income in future years, and thereby make greater use of the carryover than
would otherwise have been possible. A tax system allowing that result neither
protects vertical equity objectives nor is neutral in the choice of business
form, the two tax policy advantages initially identified for the conduit
approach.

Can such tax advantages be prevented? The statutory standard is to
require that an allocation have "substantial economic effect" in order to be
respected. If substantial economic effect is absent, the statute authorizes a
reallocation of all items in accordance with the partner's normative or
economic share of the item in question.40 The regulations interpret "substan-
tial economic effect" as encompassing two requirements: the allocation must
have "economic effect" and must pass a "substantiality" test.4 As we will
see, however, neither test is particularly effective at preventing purely tax-
motivated allocation arrangements under a conduit method of taxation.

1. Economic Effect.-The basic principle of the "economic effect"
test is that tax items may be allocated to partners only in the same manner
in which they share the economic burdens and benefits relating to those
items.42 In other words, a partner may be allocated a $100 share of the
partnership's taxable income only if the partner is also allocated $100 of the
partnership's economic benefit relating to the taxable income. The partner
may be allocated a $100 tax loss by the partnership only if the partner must
suffer the $100 economic detriment relating to that loss.

As a technical matter, the regulations implement this principle by
focusing on the book capital accounts of the individual partners, the accounts
which describe the economic relationship of the partners between and among
themselves and specify what their respective rights are upon a liquidation of

40. See IRC § 704(b).
41. See Regs. § 1.704-1(b)(2)(i).
42. See Regs. § 1.704-1(b)(2)(ii)(a) (to be valid, a tax allocation "must be consistent

with the underlying economic arrangement of the partners. This means that in the event there
is an economic benefit or economic burden that corresponds to an allocation, the partner to
whom the allocation is made must receive such economic benefit or bear such economic
burden"); cf. Regs. § 1.701-2(a)(3) ("... the tax consequences under subchapter K to each
partner of partnership operations and of transactions between the partner and the partnership
must accurately reflect the partners' economic agreement and clearly reflect the partner's
income...").

[Vol 4:3



The Future Taxation of Private Business Firms

the firm. To have economic effect, the capital accounts must be maintained
in a certain way, be adjusted in the same manner as the tax allocation, and
be respected by the partners in determining their economic interests in the
partnership upon liquidation.43 The rules are lengthy and complex, and the
burden on those taxpayers who attempt to comply with them is consider-
able,4 but the basic idea is simple: if tax allocations follow comparable
adjustments to the partners' capital accounts, which are economic accounts,
and if those adjustments affect account balances which ultimately have real
economic significance to the partners, then the tax allocation will be
consistent with the economic share.

Pairing tax consequences with their economic counterparts is a
common method of trying to prevent tax avoidance because ordinarily,
assuming a tax rate of less than 100%, the underlying economic consequence
of an action outweighs the tax effect of that action. For example, one would
not expect a taxpayer to make a cash outlay of $100 merely to obtain a tax
deduction equal to that amount because the tax savings from the deduction
will be less than the amount of the cash outlay. Thus, if the availability of the
tax deduction were conditioned on the taxpayer's actual incurrence of the
$100 expense, one might have confidence that the deductions were all
legitimate. In short, the concept of "economic effect" might be a promising
method of monitoring and preventing purely tax-motivated allocations.

Unfortunately, the economic effect requirement fails to achieve its
intended purpose and does not preclude purely tax-motivated allocations. One
reason for this failure is that capital account balances only supply some
indication of the economic rights and obligations of the partners upon a
hypothetical liquidation in the current year of either the partner's interest in
the partnership or the partnership itself. Yet in the vast majority of cases,
neither of those two events is specifically contemplated by the partners, so
that a capital account adjustment resulting in a currently negative or positive
account balance may not be particularly meaningful. Rather, in most cases,
the economic outlook of the partners goes far beyond such a hypothetical
current liquidation to encompass events that may occur well in the future. In

43. See Regs. §§ 1.704-1(b)(2)(ii)(b), -1(b)(2)(iv)(b).
44. See Alan Gunn, Partnership Income Taxation 44 (2d ed. 1995) (the allocation

rules are "so difficult that only a handful of partnership-tax specialists in large firms will be
able to apply [them]"); Stephen Utz, Federal Income Taxation of Partners and Partnerships 108
(3d ed. 1995) [hereinafter Utz-Federal] (describing regulations as "monstrously complex!); see
also Michael J. Close & Dan A. Kusnetz, The Final Section 704(b) Regulations: Special
Allocations Reach New Heights of Complexity, 40 Tax Law. 307, 336 (1987); Lawrence
Lokken, Partnership Allocations, 41 Tax L. Rev. 547, 621 (1986) ("The ... regulations under
section 704(b) are a creation of prodigious complexity .... The complexity ... makes the
regulations essentially inpenetrable (sic) to all but those with the time, talent, and
determination to become thoroughly prepared experts on the subject.')

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Florida Tax Review

short, capital accounts provide at best a mere static snapshot of the economic
situation of the partners whereas their real situation may well be based on
dynamic, multi-year expectations. 5

To illustrate, suppose general partnership AB makes a special
allocation of a $200 tax loss in year 1 to partner A. In that situation, the
economic effect test simply requires that the special allocation be accompa-
nied by an allocation to A's capital account of a $200 economic burden in
year 1. But the allocation of an economic burden to A has significance only
if there is a liquidation of A's interest at the end of year 1, an event not
likely to occur and not expected by the parties. The economic effect test does
not require A to actually outlay a $200 investment in year 1 in order to
obtain the $200 tax loss. Indeed, the other partner, B, may have made all or
most of the actual investment, yet A may be allocated the entire tax loss.
Nothing in the Treasury's economic effect regulations prohibits that
outcome.46 To be sure, if there were a liquidation immediately after year 1,
then based on the capital account adjustment, A's economic share in the
venture would be reduced by $200. Again, however, liquidation is not
contemplated by the parties so that possibility may not be of significance. In
short, the economic effect requirement attempts to match the allocation and
actual claiming of a tax item with the economic burden or benefit associated
with that item, yet it completely ignores the proximity or remoteness of the
burden or benefit and, therefore, whether it will in fact ever be realized.47

In that sense, the regulatory mandate constitutes a highly complex and
extremely burdensome set of paper entries.

The regulations basically concede the "paper entry" aspect of the
economic effect requirement. Under the "transitory" leg of the substantiality
test, which (as described later) is an independent basis for invalidating an

45. Cf. Mark P. Gergen, Reforming Subchapter K: Special Allocations, 46 Tax L.
Rev. 1, 11-14 (1990); Alan Gunn, The Character of a Partner's Distributive Share Under the
"Substantial Economic Effect" Regulations, 40 Tax Law. 121, 124-25 (1986); William S.
McKee, Partnership Allocations: The Need for an Entity Approach, 66 Va. L. Rev. 1039, 1059
n.85 (1980); Utz-Federal, supra note 44, at 118; Stephen G. Utz, Partnership Taxation in
Transition: Of Form, Substance, and Economic Risk, 43 Tax Law. 693, 700-01 (1990).

46. If A's only investment in the partnership were less than $200 and the
partnership had no debt, then A's loss for the year would be limited to the amount of his or
her investment. IRC § 704(d). But if the loss were generated by partnership debt and enough
of the debt were allocated to A, which would almost always be the case, there is nothing in
the economic effect rules to prohibit A's claim of the $200 loss.

47. See Utz-Federal, supra note 44, at 117. What the parties may contemplate, and
what in fact may transpire, is a prompt special allocation of income to A in year 2 to make
up for the special loss allocation in year 1. The offsetting allocation immediately cancels out
the hypothetical economic burden assumed by A as a result of the year I allocation. Thus, in
any year after year 2, A's economic burden would have vanished, with the allocation of such
burden to A in year 1 having been a mere paper entry.

[VoL 4:3



The Future Taxation of Private Business Firms

allocation, neither a current nor future allocation will be respected if at the
time they are agreed to, there is a strong likelihood that they will offset one
another yet will reduce collective tax liabilities. 8 But if adjustments to
capital accounts have real economic significance when they are made, then
there is no particular reason why the Treasury should be concerned about the
possibility of there being offsetting future adjustments. The fact that the
Treasury is rightly concerned about that possibility is indicative of the
inconsequential nature of the initial capital account adjustment and, therefore,
the entire economic effect test.

In addition, the economic effect test is completely ineffective at
preventing the tax-motivated allocation of tax items which do not have any
economic counterpart borne by any partner. Initial examples of such tax items
include certain tax credits, depreciation and other noneconomic deductions,
and deductions attributable to nonrecourse indebtedness incurred by the
partnership. If a $100 tax depreciation deduction of a partnership has no
economic corollary (because there is no cash outlay of that amount and the
property being depreciated has in fact retained its value), to whom should the
deduction be allocated under the economic effect test?

Other even more pervasive examples of tax items without economic
counterparts are tax deductions attributable to any form of entity debt if the
owners, such as limited partners, LLC members, corporate shareholders, or
any partners of an LLP or an LLLP, are shielded from personal liability for
repayment of the debt.49 In those circumstances, it may not be possible to
award tax losses only to those bearing the economic risk of loss because no
owner may bear that economic risk. Lastly, certain tax items, such as capital
gain or tax-exempt income, have an economic counterpart but also introduce
matters of significance only for tax purposes. A dollar's worth of capital gain
and ordinary income may look the same from the perspective of a capital
account adjustment, but they may have very real differences from a tax
standpoint.

For all of these types of tax items, then, there may be no economic
touchstone on which to determine the proper allocable share of the item
belonging to the partner. The solution of matching tax allocation with
economic consequence does not work if a tax item is without any correspond-
ing economic effect or is important only because of some uniquely tax-related
reason.

48. See Regs. § 1.704-1(b)(2)(iii)(c).
49. See Karen C. Burke, The Uncertain Future of Limited Liability Companies, 12

Am. J. Tax Pol'y 13, 58 (1995) ("[t]he economic risk of loss concept is meaningless with
respect to most LLC liabilities, since no member is personally liable").

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Florida Tax Review

2. Substantiality.-Recognizing the inadequacy of the capital account
approach and the economic effect test, the regulations impose a second,
independent requirement for insulating a tax allocation from challenge. This
requirement, termed "substantiality" in a curious use of a word, focuses on
the tax minimization effect of the allocation.5" In other words, even if a tax
allocation conforms to the capital account adjustments of the partners in the
manner specified by the economic effect requirement, the allocation may still
be invalid if its effect is to minimize tax liabilities.

The substantiality requirement is manifested in several different ways
in the regulations but the strongest version focuses on the after-tax economic
consequences of the proposed allocation to the partners. Under this version
of the test, substantiality is flunked and an allocation is invalid for tax
purposes if, after the tax effects of the allocation are taken into account, no
partner is worse off and at least one partner is better off (both determined
from a present value standpoint) than the results had no special allocation
taken place." It is, in effect, a test of "tax efficiency," with a Pareto
improvement in this case being an arrangement indicative of tax avoidance
and therefore impermissible. An obvious concern with such a test is the
potential invalidation of an economically efficient allocation which just
happens to coincide with the tax efficient one. But the regulations apparently
set that concern aside as perhaps the price that must be paid to prevent tax
avoidance.

The substantiality test is sometimes difficult to apply in practice. For
example, suppose special allocations span a number of years or encompass
a number of different tax items in a given year, with all such allocations
involving, perhaps, different sharing arrangements. Which group of alloca-
tions should be taken into account in measuring the after-tax economic
consequences mandated by the substantiality test? The substantiality test
generally requires consideration of more than one allocation, yet it provides
little indication regarding exactly which allocations must be considered.52

The after-tax economic consequences of allocations may also not be
readily ascertainable. Suppose, for example, a partnership claims certain tax
depreciation deductions with respect to an investment in a building and

50. See Regs. § 1.704-1(b)(2)(iii).
51. See Regs. § 1.704-1(b)(2)(iii)(a).
52. For certain incarnations of the substantiality test, but apparently not for the

strongest version of it, the regulations apply a five-year cut-off rule. See Regs. § 1.704-
l(b)(2)(iii)(c) (flush language). Hence, offsetting allocations occurring more than five years
after the initial allocation under scrutiny need not be taken into account in determining whether
substantiality is met. The arbitrary five-year rule applies even though the fact of the offsetting
allocation is reasonably fixed and certain at the time of the initial allocation. See Regs.
§ 1.704-1(b)(5), ex. (2).

[Vol. 4:3



The Future Taxation of Private Business Firms

disproportionately allocates the deductions to one partner. Suppose the same
partner is allocated any tax gains resulting from a disposition of the building
up to the amount of depreciation allocated to such partner. Under the
strongest version of the substantiality test, it might be argued that the partner
has obtained an after-tax economic benefit from the allocation if the building
is reasonably expected to hold its value over the period of the allocations. In
that case, the partner will likely receive an economic gain to offset the initial
allocation of economic cost, and will obtain the tax advantage of the early
deductions.53 But such a rule presumably would not be administrable-it
would require a case-by-case analysis of property values to know whether a
particular allocation should be respected or not. Hence, the current regulations
indulge in an assumption-surely false in many cases-that the value of the
building declines each year by the amount of its book depreciation (the
"value-equals-basis" rule). Therefore, the partner in the example is deemed
to have suffered an economic detriment greater than any tax savings as a
result of the allocations, and the substantiality test is thus satisfied.'
Although the regulatory assumption may be the only feasible rule to use, it
certainly highlights the artificiality and ineffectiveness of the substantiality
requirement in this common circumstance.

Aside from these practical dilemmas, there is a more fundamental
concern with the substantiality test. As noted, the strongest version of the test
(as well as both of the weaker versions) requires a comparison: are the after-
tax consequences of the partners from the allocation better or worse than
from some other? But which other? Surely, it cannot be any other allocation,
for it must always be possible to hypothesize an allocation which is
economically no different from the one under scrutiny, yet is not as favorable
from a tax standpoint. In other words, presumably the objective of the law is
not to force tax maximization upon the partners, i.e., the least "efficient"
outcome from a tax standpoint. Rather, the concept would seem to require
identification of some normative method of allocating the particular item in
question, and a comparison with the tax consequences of that normative
method. Yet in many cases, the proper normative method of allocating an

53. One assumes that normal arm's length bargaining will protect the other partners
from suffering a net after-tax detriment from the special allocation. So long as the tax
disadvantage to those partners due to their loss of the early deductions is less than the tax
benefit to the partner who is allocated a disproportionately large share of those deductions, the
parties can split the net tax savings with the only loser being the Treasury and taxpayers
generally.

54. See Regs. §§ 1.704-1(b)(2)(iii)(c) (flush language), -l(b)(5), ex. (1)(xi). The
assumed decline in value of the building means that there will be no offsetting gain belonging
to the partner upon disposition of the property.

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Florida Tax Review

item-presumably the economic allocation-may not be known or know-
able.5

In summary, substantiality seems like a promising test for preventing
tax avoidance but it cannot work for much the same reason economic effect
does not work. Both tests require knowledge of the owners' economic shares
of the various burdens and benefits of the entity. But where those burdens
and benefits are retained by the entity and not distributed to or assumed by
the owners directly, there may be no feasible method of ascertaining what the
economic shares are.

3. Subjective Purpose.-In part in recognition of the inadequacy of
both the economic effect and substantiality tests, the Treasury recently
promulgated a general "anti-abuse" regulation in the partnership area. The
regulation expressly grants the Commissioner authority to recast a partnership
transaction if a principal purpose of the transaction is to reduce substantially
the present value of the partners' aggregate federal income tax liability in a
manner that is inconsistent with the intent of subchapter K.56 The
recharacterization may take place "even though the transaction may fall
within the literal words of a particular statutory or regulatory provision."57

Thus, even if an allocation complies with the complex and extensive
regulatory requirements for special allocations and passes both the economic
effect and substantiality tests, it might still be invalidated under authority of
the new Treasury rule.5"

Despite the formidable tone of this new regulation, it likely will not
prove to be an effective tool in preventing the tax advantages available from
special allocations. For one thing, as ultimately promulgated, the regulation
takes a liberal, "hands-off' attitude towards special allocations. For example,
it explicitly blesses rules adopted for "administrative convenience," such as

55. See Gunn, supra note 44, at 53-54; Close & Kusnetz, supra note 44, at 321. The
regulations require comparison with a hypothetical situation in which the allocation under
scrutiny is not included in the partnership agreement. See Regs. § 1.704-1(b)(2)(iii)(a)(1) and
(2), (b)(1) and (2), and (c)(1) and (2). Obviously, that instruction provides little guidance
regarding the proper normative share of the partners.

56. See Regs. § 1.701-2(b).
57. See id.
58. See Regs. §§ 1.701-2(c)(5) (allocations complying with the literal language of

the regulations are nevertheless subject to scrutiny under the anti-abuse regulations if the
results of the allocations are "inconsistent with the purpose of section 704(b) and those
regulations"), -2(b)(4) (one weapon of Commissioner in implementing anti-abuse regulations
is to reallocate partnership items).

[Vol. 4:3



The Future Taxation of Private Business Firns

the value-equals-basis rule, which are key to insulating certain allocation
arrangements from IRS challenge.59

Even if that explicit blessing were removed, however, the basic
design of the anti-abuse regulation undermines its effectiveness. For example,
by focusing on whether or not there has been a substantial reduction in the
present value of aggregate tax liabilities, the regulation encounters the same
difficulty facing the substantiality test: the "as compared to what" inquiry.
Indeed, the answer to that question provided by the new regulation is even
less satisfactory than the one provided in the substantiality test. In substantial-
ity, the comparison is with a result produced by a normative, economic
sharing of the item in question, something, unfortunately, that may not be
known in certain cases. In the new regulation, the answer is to compare with
an outcome consistent with "the intent of subchapter K," an even less well-
defined standard.

Further, the regulation is only operative if a subjective intent test is
satisfied. "A principal purpose of the transaction" must be to reduce tax
liabilities in the forbidden way. Aside from the practical difficulty of knowing
whose purpose must be determined and how it should be ascertained, this
aspect of the regulation raises the normative question of why tax results
should turn on one's state of mind in the first place.' If the partnership tax
rules somehow permit tax outcomes that the Treasury considers inappropriate,
the solution should be to fix the rule rather than simply to prejudice those
taxpayers who take advantage of the rule with the wrong mindset.

4. Would Some Other Test Be Effective?-As dismal as the current
Treasury regulations are in this area, the problem lies not with them. Rather,
the problem is that the regulations are trying to achieve something which
cannot be done. As detailed above, the conduit model requires the existence
of an economic baseline against which a tax allocation can be tested. Yet so

59. See Regs. § 1.701-2(a)(3), -2(d), ex. (6) (application of value-equals-basis rule
respected by anti-abuse regulation), -2(d), ex. (5) (special allocation scrutinized by anti-abuse
regulation but respected).

60. See American Law Institute, Federal Income Tax Project-Subchapter
K-Proposals on the Taxation of Partners 245 (1984) [hereinafter ALI 1984 Subchapter K
Proposals] (arguing against subjective intent test in determining validity of tax allocation);
Walter J. Blum, Motive, Intent and Purpose in Federal Income Taxation, 34 U. Chi. L Rev.
485, 515 (1967) ("If tax-reducing actions are to pass muster but tax avoidance actions are to
be penalized, some way of distinguishing between the two must be located. The trouble is that.
as a mental phenomenon, a desire to minimize taxes does not differ from a desire to avoid
taxes"); Edwin S. Cohen, Taxing the State of Mind, Tax Executive, Apr. 1960, at 200, 218
("to [make tax consequences] depend upon selecting and weighing the motives or state of mind
which prompted his action is a far more complex assignment, and one which I believe we
should endeavor to avoid").

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Florida Tax Review

long as there is state law separation between the entity and the owners-that
is, the owners do not, in fact, own the assets directly but instead only own
interests in the firm which owns the assets-the economic baseline against
which the tax allocation needs to be compared is necessarily missing. For
example, we simply don't know how the partners would have shared
undistributed income earned by a firm had there, in fact, been a distribution
of that income in the year it was earned. Indeed, in many cases, the partners
themselves don't even know how they would have shared the income,
because their "deal" extends far beyond the economic outcome of the first
year. But without that piece of information, it is not possible to fashion a
workable rule that can ferret out purely tax-advantaged allocation arrange-
ments under a conduit model of taxation."

5. Summary.-To summarize the argument up to this point, this
article has contended that as a theoretical matter, the conduit method of
taxing the income of private business firms is appealing because it can protect
vertical equity norms and minimize distortions in the choice of business form.
The practical reality, however, is that the conduit model may not accomplish
either objective very well while imposing extremely high transactions costs
on both taxpayers and the IRS.

The central flaw of the conduit model is its inability to provide
assurance that the proper amount of business income and loss for any given
year is allocated and taxed to the proper owner. Under the conduit model,
allocations of the firm's tax items have no grounding in economic substance
due to the absence of an economic baseline against which the allocation can
be tested. In addition, the validity of allocations cannot even be tied to
matters of legal form because it is the firm, and not the owners, that
maintains legal ownership of the items in question. As a result, the conduit
approach is unable to protect vertical equity norms; that objective may be
thwarted, for example, by allocating to a high-bracket owner a
disproportionately small share of the firm's income for a given year. Further,
the choice of business form is distorted by the existence of tax advantages
available only to businesses with more than one owner which are taxed as
conduits. Although the law has certainly evolved well beyond its state in
1954, Professor Surrey's concerns at that time with the potential flexibility
of special allocations still seem to be appropriate.62

61. See Gergen, supra note 45, at 10-11 ("[qluite simply, there is no dependable
way to distinguish tax motivated allocations from allocations with an economic basis"); cf.
Gunn, supra note 44, at 53-54.

62. See supra note 38 and accompanying text.

[Vol 4:3



The Future Taxation of Private Business Firms

C. Which Approach Would Be More Administrable?

The discussion thus far would seem to have exposed major flaws in
both conduit and entity taxation. Although the latter would tax the business
income at the wrong rate, the former cannot provide assurance that the
business tax base is taxed to the right taxpayer. So which approach is
preferable?

There is no easy answer to that question. Concerns about the ease
with which the IRS can administer the rules and taxpayers can comply with
them, however, should obviously play a role in deciding the preferred
approach. Otherwise, any rules which are developed risk being a mere facade,
a nice theoretical way of imposing taxes on business income that is not
matched by real world consequences to most taxpayers. Administrability
concerns are particularly significant given the applicability of the rules to
taxpayers who are in diverse business arrangements and who may have
widely differing levels of sophistication and tolerances for complexity.

The conduit tax system epitomized by subchapter K is notoriously
difficult to comprehend and apply. Many analysts have suggested that there
may be widespread disregard of one or more of the existing rules because of
the inability of firms and their advisors to apply them correctly and of the
IRS to administer them. Indeed, back in 1986-which might properly be
described as a time when complexity in subchapter K was still in a state of
infancy-one tax expert estimated a mere 2-1/2% compliance rate with one
particular partnership provision.63 More recently, another distinguished tax

63. Hearings Before the Subcommittee on Select Revenue Measures of the U.S.
House Committee on Ways & Means on Issues Relating to Passthrough Entities, 99th Cong.,
2d Sess. 56 (1986) [hereinafter Hearings] (statement of Joel Rabinovitz) (§ 751(b) is probably
overlooked in 90% of the cases in which it applies, is ignored in another 5% of the cases
because the cost of compliance would be so high, and is misapplied by the IRS in another 2-
1/2% of the cases). See also Sheldon I. Banoff, The Use and Misuse of Anti-Abuse Rules, 48
Tax Law. 827, 829 n.17 (1995) (describing how most taxpayers and their advisors "employ
a 'common sense' approach to the tax law (i.e., it is cheaper to guess the right answer than
to research it thoroughly; it is easier to take an aggressive reporting position than it is to plan
prophylactically; it is simpler to make a 'reasonable' estimate than to compile detailed records
of substantiation)"); Curtis J. Berger, W(h)ither Partnership Taxation?, 47 Tax L Rev. 105,
107-08 (1991) (subchapter K "has become one of the most inaccessible and burdensome
features of the entire tax system"); Burke, supra note 49, at 57 ("ilt is already widely
perceived that many small (and even some large) partnerships fail to comply strictly with the
detailed requirements of Subchapter C'); Pamela Olson, Some Thoughts on Anti-Abuse Rules,
48 Tax Law. 817, 824 (1995); Joseph A. Snoe, Economic Reality or Regulatory Game
Playing?: The Too Many Fictions of the § 752 Liability Allocation Regulations, 24 Seton Hall
L. Rev. 1887, 1888-90 (1994).

In the allocation area, noncompliance might be broken down into at least three
categories: failure to establish and utilize mandated procedures (for example, failure to

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Florida Tax Review

expert, a former Chief Counsel of the IRS and Chair of the ABA Section of
Taxation, has conceded the need to enlist expert assistance to give advice on
core portions of the partnership tax law.' In addition, the General Account-
ing Office has reported on the ineffectual nature of the IRS's strategy for
insuring compliance among partnerships and their partners. 65

Furthermore, as noted above, the partnership tax rules were made
even more difficult by the recent adoption of a general "anti-abuse"
regulation in subchapter K. Although there continues to be some disagree-
ment as to the meaning and scope of the regulation, as well as its wisdom
and validity,66 the adoption of the regulation is certainly not a positive

maintain book capital accounts in the required manner or failure to include certain boilerplate
provisions in the partnership agreement), failure actually to follow through on provisions in
the partnership agreement mandated by the tax authorities (for example, refusal by the partners
to make liquidating distributions in accordance with their capital account balances despite
statements in the agreement that they will do so), and failure to satisfy legal standards (for
example, failure to meet the substantiality test). One suspects that many smaller partnerships
that are not particularly well-advised never even encounter the second and third set of issues
because of their failure to satisfy one or more of the first type of requirements. Larger and
better-advised partnerships may, in fact, clear the first hurdle by meeting the technical
requirements of the first category of issues, but there is still doubt whether their actual
behavior conforms to the specific provisions of their agreements. Recall that in the classic case
of Orrisch v. Commissioner, 55 T.C. 395 (1970), aff'd per curiam, 31 A.F.T.R.2d 73-1069 (9th
Cir. 1973), where the special allocation of the taxpayers was invalidated, the problem was not
the taxpayers' failure to maintain capital accounts correctly but, instead, doubt on the part of
the court that the taxpayers would actually respect the account balances when a liquidation
took place. At a 1996 ABA Tax Section meeting of the partnership committee, there was a
similar discussion regarding whether clients really permit liquidating distributions to be made
in accordance with their capital account balances when their agreement specifies that outcome.
Finally, because of the amorphous nature of the substantiality test, there is serious question
whether those partnerships satisfying the first two hurdles in fact comply with the third.

64. See N. Jerold Cohen, It Always Looks Better When You Look Back, 46 Tax
Law. 683, 684 (1993).

65. See U.S. General Accounting Office, IRS' Partnership Compliance Activities
Could Be Improved, GAO/GGD-95-151 (1995), reprinted in 95 TNT 118-21 (June 19, 1995)
(LEXIS, FEDTAX library, TNT file). The IRS is attempting to increase its audit coverage of
partnership returns. See Internal Revenue Service, Examination Program Letter-FY 1997
(Nov. 1996), p. 7, reprinted in 97 TNT 32-45 (Feb. 18, 1997) (LEXIS, FEDTAX library, TNT
file); Phil Brand, IRS Releases 1997 Examination Program Letter, 28 Tax Adviser 242 (1997).

66. Some commentary on the final version of the anti-abuse regulation includes
Sheldon I. Banoff, Anatomy of an Antiabuse Rule: What's Really Wrong with Reg. Section
1.701-2, 66 Tax Notes 1859 (Mar. 20, 1995); Banoff, supra note 63; Frank V. Battle, Jr., The
Appropriateness of Anti-Abuse Rules in the U.S. Income Tax System, 48 Tax Law. 801
(1995); Michael J. Grace, Final Anti-Abuse Regulation Expanded and Clarified, but Uncer-
tainties Remain, 12 J. Partnership Tax'n 91 (1995); Daniel Halperin, Are Anti-Abuse Rules
Appropriate?, 48 Tax Law. 807 (1995); Richard M. Lipton, The Partnership Anti-Abuse Regs.
Revisited: Is There Calm After the Storm?, 83 J. Tax'n 68 (1995); and Olson, supra note 63.

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The Future Taxation of Private Business Firms

indication of the general health of the subchapter K rules. Indeed, some of the
commentary published in response to the proposed version of the regulation
illustrates examples of transactions meeting the literal terms of the statute
and/or regulations yet reaching seemingly nonsensical results.67

Finally, it is evident that if one were writing on a clean slate, one
would not adopt a set of operating rules like subchapter K that first touts their
flexibility,' then proceeds to restrict that flexibility with a series of highly
complex mechanical and sometimes subjective tests,' and then overlays on
top of those tests a relatively amorphous supertest authorizing the disregard
of the consequences of earlier tests despite plain compliance with them.
Indeed, the general anti-abuse rule may apparently apply to negate a
taxpayer's successful navigation of other anti-abuse rules adopted to monitor
particular types of partnership-related transactions." ° Something very
fundamental must be awry in the basic structure of the rules for the law to
have evolved into this unhappy state.

In short, the arguments against adopting a conduit tax system like
subchapter K for the taxation of private business firms are extremely power-
ful ones. Yet it is not enough simply to decry the inadequacy of one par-
ticular approach; one must try to devise a workable alternative. Although a
complete development and analysis of an entity tax approach which attempts
to impose only a single level of tax on business income is beyond the scope
of this article, some earlier analyses suggest the difficulty of that endeavor.7

67. See, e.g., New York State Bar Association Tax Section, Report on the Proposed
Partnership Antiabuse Rule, 64 Tax Notes 233 (July 11, 1994) [hereinafter N.Y.S.B.A. Tax
Section Report]. The recent case of ACM Partnership v. Commissioner, 73 T.C.M. 2189
(1997) illustrates another large transaction which seemed to satisfy the literal provisions of the
statute and regulations but reached an impermissible result. Cf. Regs. § 1.701-2(d), ex. 7. For
recent commentary on the ACM case, see Steven M. Surdell, ACM Partnership--A New Test
for Corporate Tax Shelters?, 75 Tax Notes 1377 (1997). For additional discussion of some of
the current problems of subchapter K, see Staff of Joint Comm. on Tax'n, Review of Selected
Entity Classification and Partnership Tax Issues 26 (Comm. Print 1997) [hereinafter 1997 JCT
Partnership Tax Study]; William D. Andrews, Inside Basis Adjustments and Hot Asset
Exchanges in Partnership Distributions, 47 Tax L. Rev. 3 (1991); and William B. Brannan.
The Subchapter K Reform Act of 1997, 75 Tax Notes 121 (1997).

68. H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 65 (1954).
69. See, e.g., Regs. § 1.704-1, -2, and -3.
70. See Regs. § 1.701-2(d), ex. (8)(iii) (general anti-abuse rule may recast

transaction already subject to (and presumably satisfying the requirements of) anti-abuse
disguised sale rule in § 707).

71. See Michael L. Schler, Taxing Corporate Income Once (or Hopefully Not at
All): A Practitioner's Comparison of the Treasury and ALl Integration Models, 47 Tax L Rev.
509 (1992) (describing implementation problems with Treasury's dividend exclusion model
of integration, a slimmed-down (and much simplified) version of CBIT, and ALI Reporter's
integration proposal); Yin, supra note 31, at 436-68.

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In addition, an entity tax system starts with the fundamental flaw of taxing
business income and losses at the wrong rate and not permitting the netting
of related tax items. Finally, it also presents greater transitional concerns than
adoption of a conduit system.72

To illustrate just one of the problems in implementing an entity tax
approach, consider a scheme in which business income is taxed once at the
entity level with distributions of already-taxed income then being tax-free to
the owners of the firm. Such an approach, termed the "dividend exclusion
prototype," was recommended by the Treasury Department in 1992 because,
among other reasons, it represents "the most straightforward and easily
administered" method of integration considered by the Department. 3

Consider just the single issue of how capital gain or loss arising upon a
transfer of the ownership interests of a firm should be taxed under such a
system.74

In theory, any capital gain or loss might reflect some combination of
(1) income accumulated by the firm which has already been subject to the
entity-level tax, (2) accumulated preference income which has escaped the
entity-level tax, and (3) unrealized gains and losses of the firm (including the
value of the firm's projected profits and losses). Neither the fully-taxed
income nor the preference income should be taxed again upon the transfer of
ownership interests, assuming there is a policy decision to pass through
preferences. Presumably, however, there should be a tax on the capital gain
or loss representing the unrealized entity-level gain or loss. How should the
rules be designed to tax this last element while not taxing the portion of the
capital gain or loss representing accumulated, previously taxed income or
preference income?

One rough method of accomplishing that end, suggested by both the
Treasury Department and the ALI Reporter in their integration proposals, is
to provide outside basis adjustments equal to the fully-taxed and preference
income (assuming passthrough of preference income) not distributed by the

72. Requiring all private business firms to be taxed in the same way, either under
a conduit or an entity tax approach, would present transitional problems because of the change
from current law. A conduit approach, however, is already in effect for those firms currently
subject to subchapters K or S. In contrast, an entity tax approach imposing only a single level
of taxation on business income would represent a new system for all firms.

73. U.S. Dep't of Treasury, A Reconmendation for Integration of the Individual and
Corporate Tax Systems, Dec. 1992, letter from Nicholas Brady, Secretary of the Treasury, to
Dan Rostenkowski, Chairman, U.S. House Comm. on Ways and Means, p.1.

74. Any gain or loss on the sale of ownership interests need not, of course,
constitute capital gain or loss. The reference in the text to capital gain or loss is simply
shorthand for the gain or loss arising from the sale of ownership interests, no matter what the
actual character of that gain or loss is.

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The Future Taxation of Private Business Firms

firm.' Analytically, the procedure, termed a "dividend reinvestment plan'"
or "DRIP" by the Treasury, would allow firms to retain their earnings but to
declare constructive distributions followed by constructive reinvestments of
those amounts back to the firm. The distributions would be tax-free to the
distributees, and the reinvestments would produce the desired increase in
outside basis. At least in theory, if all retained earnings were made subject to
a DRIP, then capital gain and loss would reflect only unrealized gains and
losses at the firm level. If such gain and loss were taxed, an inside basis
adjustment could be made to preclude the same gain or loss from being taxed
again when realized by the firm.

A DRIP, however, is nothing more than an allocation of undistributed
income among the owners of the firm, the core requirement of existing
subchapter K. Although the ramifications of a DRIP under an entity-level tax
would be less significant than under subchapter K because the income being
allocated under the DRIP would already have been subject to tax, neverthe-
less the practical difficulties with the allocation would be the same. If a set
of rules could be developed to specify the appropriate outside basis
adjustments for private business firms with tiers of owners and preferential,
contingent, and inchoate ownership interests, among other things, those same
rules could be utilized to implement a conduit tax system. In addition, the
necessary, accompanying inside basis adjustment might encounter the same
problems as under the current law of subchapter K.76

Both the Treasury and the ALI Reporter suggested an elective DRIP
to be fashioned by the taxpayer. But an elective DRIP would still face the
same problems, the only difference being that there would be an initial, ad
hoc development of taxpayer-favorable allocation schemes. Also, in certain
circumstances, firms might find it advantageous from a tax standpoint not to
distribute constructively all of their retained earnings. No doubt, there would
follow the inevitable Congressional and Treasury responses to those
schemes-like a "substantial economic effect" test in order to validate a
DRIP-with resulting considerable complication. In short, adoption of a DRIP
may encounter many of the same daunting allocation problems now dealt
with under subchapter K.

Another possible solution is to tax the capital gains, forgo a DRIP
and any basis adjustments, and simply permit the liberal utilization of capital
losses. The theory is that to the extent the capital gain ought not be taxed
because it represents fully-taxed or preference income accumulated by the

75. See Treasury Integration Report, supra note 28, at 87-88; American Law
Institute, Federal Income Tax Project-Integration of the Individual and Corporate Income
Taxes-Reporter's Study of Corporate Tax Integration 126-27 (1993) (proposal 5) [hereinafter
ALI Reporter's Integration Study].

76. See IRC §§ 734, 743, and 755.

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Florida Tax Review

firm, there will subsequently be an offsetting capital loss to the purchaser of
the ownership interest when the income is distributed out of the firm. Thus,
so long as the capital loss can be easily utilized, overall double taxation
would be avoided. One problem with this approach, however, is that the
offsetting capital loss may not arise until many years after the capital gain is
incurred and the tax is paid. Further, there is a potential rate arbitrage
problem: the seller who incurs the capital gain may not be taxed at the same
rate as the purchaser who obtains the capital loss. Finally, full taxation of
capital gains without a DRIP, even with liberal availability of capital losses,
might place undue pressure on firms to distribute their earnings.

The opposite approach, also suggested by the Treasury Department,
would be to exempt the capital gain from taxation.77 As noted, the only
element of the capital gain that ought to be taxed is the amount equal to the
unrealized gains or losses at the firm level. But such gains or losses can be
taxed when realized by the firm. Thus, a capital gains exemption (and, of
course, nonrecognition of capital losses) would still permit a single tax to be
collected ultimately on all income earned by the firm. Moreover, it would do
so in a very simple fashion, without the need of a DRIP or inside basis
adjustments.

The principal problem with this idea is the deferral that would be
permitted, and the resulting distortions potentially created. If an acquisition
of the ownership interests of a firm were tax-free but the acquisition of the
firm's assets were not, there would be a clear bias in favor of the former
transaction. This bias might be similar to or even greater than the bias under
current law of an acquisition of corporate stock (which ordinarily results in
only one tax) over an acquisition of the corporation's assets (which may
result in two taxes). To be sure, the magnitude of the bias is uncertain. It
might be offset to some extent by an implicit tax imposed in the capital gains
transaction if the price for the ownership interests takes into account the
unrealized gains and future tax liability at the entity level. Nevertheless,
because taxation of those gains would continue to be deferred, the implicit
tax would likely be much smaller than the explicit tax arising on an asset
sale, so that some distortion would be caused.

Accelerating entity-level realization events would reduce the
distortion because it would cause the implicit tax to be closer in amount to
the explicit tax. For example, exemption of capital gains might be accompa-
nied by a mandatory section 338-type rule triggering an entity-level
realization event upon a sufficient change in ownership of a firm. But
implementing a mandatory section 338 regime would be extraordinarily

77. See Treasury Integration Report, supra note 28, at 83.

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The Future Taxation of Private Business Firms

difficult.78 It would in most cases force an undesirable result on the
taxpayer, in contrast to existing section 338 which was originally designed to
provide a taxpayer-favorable election. Thus, the major thrust of the qualifica-
tion rules in a mandatory section 338 environment would be to devise a net
from which the taxpayer could not escape, much like the rules for section
382, surely no model for simplicity.79

In summary, achieving the proper tax treatment of capital gains in an
entity tax system would present a formidable challenge and is illustrative of
the difficulties to be encountered in devising such a system. There are the
same age-old trade-offs between equity and simplicity, with the price of
"getting it right" in an entity tax system being perhaps as high as doing so
in a conduit system.

D. Summary and Conclusion

As difficult as it is to implement a conduit tax system, there does not
seem to be any clear advantage to developing an entity tax approach for the
taxation of private business firms. Each system, as implemented, includes
certain basic flaws in the taxation of business income. In addition, each
system may encounter similar problems in facilitating taxpayer compliance
and IRS review. An entity tax approach has the additional disadvantage of
presenting greater transitional concerns.

But this rather pessimistic resolution of this issue would seem to
create a dilemma for policymakers. If subchapter K, the most refined conduit
system in existence, is already viewed as placing intolerable burdens on
taxpayers and the IRS alike, and further, necessary reforms would likely
make it even more difficult to comply with and administer, then how can that
subchapter be mandated as the uniform method of taxation for all private
business firms? Wouldn't such a recommendation simply lead to disregard of
the law even more widespread than at the present time?

This article suggests a way out of that dilemma. Specifically, two
versions of conduit taxation should be pursued. One version should reform
subchapter K to prevent potential abuses of those rules even at the cost, if
necessary, of some additional complication. Subchapter K, as reformed, will
sometimes be referred to as the "default version of conduit taxation" in this
article. The other version should focus on providing an administrable set of
conduit rules with some concession, if necessary, to not achieving the correct

78. See George K. Yin, A Carryover Basis Asset Acquisition Regime?: A Few
Words of Caution, 37 Tax Notes 415, 418-20 (Oct. 12, 1987).

79. Still another possible approach would be to tax the capital gains but to permit
such gains to be excluded from income if the taxpayer agrees to accelerate the entity-level
gains. Cf. IRC § 338(h)(10).

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Florida Tax Review

outcome in all cases. The next part of the article describes the theory behind,
and the specific provisions of, the simplified version of conduit taxation."

IV. A SIMPLIFIED VERSION OF CONDUIT TAXATION

A. Introduction

Development of the simplified version of conduit taxation described
in this article used subchapter K as its starting point. This point of departure
might seem odd given the complex nature of that subchapter. On the other
hand, subchapter K represents the purest version of conduit taxation in
existence. As explained in greater detail in the next section, the theory was
to begin with subchapter K and to try to strip off as many of the complicating
features of the law as possible in order to develop a simple core of conduit
principles and rules. The key was in fashioning eligibility rules which would
enable one to discard the "extraneous" portions of subchapter K.

Subchapter S was not selected as the initial model because of its
entity tax features which seemed inconsistent with a conduit tax objective.
Those features are a natural outgrowth of subchapter S's original application
only to corporations and its close relationship with subchapter C. But they
seemed to make subchapter S an unsound foundation on which to construct
a simplified conduit version applicable to all forms of business organiza-
tion."

Despite this initial step, the proposal has evolved into one which has
a strong resemblance to subchapter S. In part, this result can be explained by
the historical roots of that subchapter. Subchapter S was enacted in 1958 to
reduce the impact of tax consequences on the choice of business form and to
remove the double tax burden on, and permit the passthrough of losses by,

80. Consideration of possible subchapter K reforms for the default version of
conduit taxation is beyond the scope of this article. One commentator has suggested a similar
"two-track" approach except that he would develop an entity tax system to be mandatorily
applicable to those firms not qualifying for his simple conduit approach. See Jeffrey L. Kwall,
Taxing Private Enterprise in the New Millennium, 51 Tax Law. 229 (1998).

81. Interestingly, one of the "entity" tax features of subchapter S-the requirement
that a firm recognize gain upon a distribution of appreciated property-was included in
subchapter S in 1982 prior to its inclusion in subchapter C. Later amendments in 1984 and
1986 extended and expanded the rule in subchapter C, thereby making the S rule superfluous.
See Subchapter S Revision Act of 1982, Pub. L. No. 97-354, § 2, 96 Stat. 1669, reprinted in
1982-2 C.B. 702, 706 (enacting former IRC § 1363(d)); Deficit Reduction Act of 1984, Pub.
L. No. 98-369, § 54(a)(1), 98 Stat. 494, 568 (amending former IRC § 311(d)(1)); Tax Reform
Act of 1986, Pub. L. No. 99-514, § 631(a), (c), 100 Stat. 2085, 2269, 2272 (amending IRC
§§ 311, 336).

[Vol. 4:3



The Future Taxation of Private Business Firms

small businesses.' Although the creation of an administrable set of provi-
sions was not stated as a specific objective, it is evident that Congress
included consideration of that goal in crafting the rules.8 Whether Congress
has achieved that goal is a matter of some disagreement,' but most
observers surely would agree that subchapter S is simpler than subchapter
K 5 Thus, in trying to develop a simplified conduit approach to a particular
tax issue, it was natural to consider the rule in subchapter S. Indeed, for
reasons explained below, the basic structure of subchapter S serves as a
remarkably coherent version of a simplified conduit system.

Subchapter S provided another important advantage. One worry in
trying to fashion a simpler set of rules is the possibility that they will not
adequately protect the fisc. Elimination of complicated subchapter K
provisions intended to prevent inappropriate tax outcomes might result in
such outcomes being resurrected within the simplified conduit system.
Subchapter S, however, offers an instructive 40-year track record of taxpayers
and transactions subject to those rules. Thus, if an inappropriate transaction
has not arisen under that subehapter, it may be indicative of the experience
one could expect under a new system modeled after one or more of its rules.

A difficulty with relying too heavily on subchapter S, however, is its
somewhat perverse relationship to subchapter K Assuming that use of the
simplified conduit version is a matter of explicit or transactional election by
the taxpayer, then the substantive tax outcomes under that version must be
compared to those under the default conduit version, i.e. some variation of
subchapter K. Unless the results under the simplified version are roughly
equivalent to (or indeed, more taxpayer-favorable than) the results under the

82. See S. Rep. No. 1983, 85th Cong., 2d Sess. 87 (1958), reprinted in 1958-3 C.B.
922, 1008.

83. For example, in explaining the reason for the one class of stock rule contained
in an early proposal of what eventually became subchapter S, the Senate report describes the
"great complications" that would arise under a contrary rule. See S. Rep. No. 1622, 83rd
Cong., 2d Sess. 453-54 (1954) (Serial Set 11735).

84. See Burgess J.W. Raby & William L. Raby, S Corporation AAA and
OAA-Alphabet Soup or Taxpayer Stew?, 78 Tax Notes 1013, 1013 (1998) (describing
subchapter S as "remarkably complicated'); Michael L. Schler, Initial Thoughts on the
Proposed "Check-the-Box" Regulations, 71 Tax Notes 1679, 1684 (1996) (subchapter S is
"extraordinarily complex").

85. See Berger, supra note 63, at 110 (greater reliance upon the "relatively simple
foundation of subchapter S, rather than upon the intricately ornate base of subchapter K (would
permit] most of the arcane complexity from this sector of tax law [to disappear]"); Martin D.
Ginsburg, Maintaining Subchapter S in an Integrated Tax World, 47 Tax L Rev. 665, 669
(1992) ("one thing that makes subchapter S look really good is subchapter K. the awesomely
complex partnership tax provisions"); Deborah H. Schenk, Commentary: Complete Integration
in a Partial Integration World, 47 Tax L. Rev. 697, 712 (1992) ("one of the hallmarks of
subchapter S is its ... simplicity [relative to subchapter K].').

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Florida Tax Review

default system, use of the simplified version might well be discouraged. Yet
current subchapters K and S do not have that relationship. Subchapter S is
simpler than subchapter K but it also generally produces tax results less
favorable to taxpayers. As a result, some commentators have predicted the
demise of subchapter S and some have even urged its repeal.8 6

For reasons described in part II, this article contends that it is
important to preserve a simplified version of conduit taxation for as many
private business firms as possible. To accomplish that end, it is necessary to
reconfigure somewhat the tax consequences under subchapters S and K. Far
from being repealed, the former should generally be liberalized; in contrast,
some of the vaunted flexibility of the latter should be curtailed. The challenge
is achieving the right balance: liberalization of subchapter S should not result
in any significant loss of simplicity, and modifying subchapter K should not
cause it to produce significantly incorrect results.

The next section describes the theoretical underpinning of the
simplified version of conduit taxation. It explains why the availability of
"simple" rules is necessarily tied to the characteristics of the firms and
owners subject to those rules. Accordingly, the proposal limits applicability
of the simplified version to a subset of private business firms referred to in
this article as "simple private business firms" (SPBFs). Section C then
outlines the basic operating provisions of the simplified system, which
generally consists of a liberalized version of subchapter S.

B. Eligibility for the Simplified Version: Theory and Definition

Over 40 years ago, the reporters and two consultants to the ALl
project on partnership tax described the source of the difficulty in subchapter
K in the following way:

Most of the problems encountered in the partnership area are
concerned with the distribution of the burden of taxation among the
members of the group. Since the Treasury from the standpoint of tax
policy is not greatly concerned about this allocation, the issues are

86. See Jerome Kurtz, The Limited Liability Company and the Future of Business
Taxation: A Comment on Professor Berger's Plan, 47 Tax L. Rev. 815, 831 (1992) (predicting
demise); Schler, supra note 84, at 1684-85 (urging repeal); Walter D. Schwidetzky, Is It Time
to Give the S Corporation a Proper Burial?, 15 Va. Tax Rev. 591, 593 (1996) (same); Willard
B. Taylor, Beyond Check-the-Box-Neglected Issues, 75 Taxes 671, 674 (1997) (same);
compare Ginsburg, supra note 85, at 665 n.3 ("[w]hile in the past some have suggested
replacing subchapter S with an extension of subchapter K to electing corporations, a
proposition that commends itself mainly to those who find the level of complexity in federal
tax law much too low .... ).

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9The Future Taxation of Private Business Firms

essentially not between Treasury and taxpayer-partner but between
partner and partner."

The passage of time since publication of that statement has revealed
that the authors were only partly correct. Certainly, one of the principal
difficulties of partnership tax has been the distribution or allocation of the tax
burden of the business firm among the owners of the business. But in contrast
to the second sentence of the quoted statement, which lay the groundwork for
the authors' proposal of what is now section 704(a), it would appear that the
Treasury Department is greatly concerned with the manner of allocation. For
example, the regulations under section 704 evidence Treasury's concern that
the flexibility of the subchapter K rules will be used to shift tax items from
one owner to another. This concern is not limited to the possibility that
income will be shifted from high-taxed to low-taxed persons, while
deductions flow from the low-taxed to the high-taxed. Also included are
possible shifts of particular categories of income-section 1231 gains and
losses, foreign-source income and deductions, capital gains and losses, and
so forth. Moreover, the shift need not necessarily be within a particular time
period. The shifting of income, losses, and other tax items recognized in
different time periods may also be objectionable.'

This section attempts to identify the characteristics of firms for which
the second sentence of the ALI reporters' statement would also be true, that
is, firms whose tax issues would be essentially between owner and owner
rather than between the Treasury and the taxpayer. If the characteristics of
such firms (termed "SPBFs") offer only limited potential for the type of tax
advantages that the Treasury is worried about, then the firm can be provided
with an operating rule structure consisting of a stripped-down version of
subchapter K, one that eliminates many of the administrative and compliance
requirements of those provisions. To be sure, the eligibility conditions of an
SPBF cannot be so precise as to preclude every possible instance of the firm
being used to achieve an advantageous tax result. Nevertheless, the objective
of the SPBF proposals is to balance a concern of protecting the fisc with a
desire to provide an administrable set of tax operating rules for as many firms
as possible.

The SPBF definition contains two basic eligibility conditions similar
to those used in defining an S corporation. First, the owners of an SPBF must
generally all be individuals. In addition, an SPBF may have only one class

87. J. Paul Jackson, Mark H. Johnson, Stanley S. Surrey & William C. Warren. A
Proposed Revision of the Federal Income Tax Treatment of Partnerships and
Partners-American Law Institute Draft, 9 Tax L. Rev. 109, 112 (1954).

88. Cf. ACM Partnership v. Commissioner, 73 T.C.M. 2189 (1997); Regs. §§ 1.701-
2(d), ex. (7), 1.704-1(b)(2)(iii)(c) (transitory allocations invalid).

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Florida Tax Review

of residual ownership interests. The terms and rationale for these conditions
are discussed in further detail below. A final section explains why other
conditions are not proposed.

1. Ownership Limitations.-As noted, one of the principal reasons
for the tremendous complexity in subchapter K is the desire to prevent the
shifting of tax items from one owner to another. Shifting strategies, however,
are only advantageous if the parties participating in the shift are in different
tax situations. Thus, if all owners of a private business firm have and
continue to have exactly the same tax profile, many of the protective rules of
subchapter K could be eliminated. As a practical matter, of course there are
far too many potential tax differences among taxpayers to ever insure, other
than on a case-by-case basis, absolutely identical tax profiles among the
owners of a private business firm. But if, for example, all owners of a subset
of firms were in at least the 28% marginal income tax bracket, it might be
unlikely that such firms would be utilized on a widespread basis to gain the
potential tax advantages from certain shifting strategies. s9 An important goal
of the ownership limitations described in the next sections is to try to insure
that owners of an SPBF will have more-or-less the same general tax profile.

a. Individuals as Owners.-The following Table 1 breaks
down by AGI class the number of individual income tax returns on which
either partnership or subchapter S income or loss was reported in 1994, the
latest year for which such data is available. An examination of the tax profile
of individuals who have invested in partnerships and S corporations in the
recent past offers some insight into the likely profile of the individuals who
will be future SPBF owners.

89. One might expect that the transaction costs of shifting would make it
uneconomic if the shifting of income and losses or deductions occurred between taxpayers in
the 28% bracket and those in the 36% or 39.6% bracket. This broad generalization ignores the
potential advantage of shifting particular tax items, such as § 1231 gains and losses, capital
gains and losses, and passive income and losses, the advantage from which is not necessarily
a function of the marginal income tax bracket of the taxpayer. That concern is addressed later
in connection with the rule limiting an SPBF to one with a single class of residual ownership
interests.

[Vol 4:3



The Future Taxation of Private Business Firms

Table 1
Number of Individual Income Tax Returns

Reporting Partnership or S Corporation Income or Loss,
by AGI Class (1994)

(numbers in 000s)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

AGI #rets. %of CuM% #w/ %tot. Cum% #w/ %tot CuM% #w/ %toz CuM%
Class filed total of col. K&S w/K&S of col. K&S wlK&S of col. K&S W/K&S of coL
(S00) rets. (3) inc. inc. (6) loss loss (9) ':'--' -'"-A (12)

0 953 0.8% 0.8% 44 1.3% 1.3% 153 7.3% 7.3% 197 3.5% 3.5%
1-5'0 14,632 12.6% 13.4% 88 2.5% 3.8% 59 2.8% 10.1% 147 2.6% 6.1%

5-10 14,235 12.3% 25.7% 122 3.5% 7.3% 77 3.7% 13.8% 199 3.6% 9.7%
10-15 13,465 11.6% 37.3% 161 4.6% 11.9% 106 5.0% 18.8% 267 4.8% 14.5%

15-20 11,411 9.8% 47.1% 185 5.3% 17.2% 89 4.2% 23.0% 274 4.9% 19.4%
20-25 9,663 8.3% 55.4% 162 4.6% 21.8% 85 4.0% 27.0% 247 4.4% 23.8%

25-30 8,121 7.0% 62-4% 147 4.2% 26.0% 105 5.0% 32.0% 252 4.5% 28.3%
30-40 12,014 10.4% 72.8% 315 9.0% 35.0% 196 9.3% 41.3% 511 9.1% 37.4%
40-50 9,024 7.8% 80.6% 267 7.6% 42.6% 198 9.4% 50.7% 465 8.3% 45.7%
50-75 13,127 11.3% 91.9% 542 15.5% 58.1% 385 18.3% 69.0% 927 16.6% 62.3%
75-100 4,784 4.1% 96.0% 365 10.5% 68.6% 202 9.6% 78.6% 567 10.1% 72.4%

100-200 3,405 2.9% 98.9% 627 18.0% 86.6% 265 12.6% 91.2% 892 16.0% 88.4%
200-500 890 0.8% 99.7% 342 9.8% 96.4% 138 6.6% 97.8% 480 8.6% 97.0%
500-1000 149 0.1% 99.8% 81 2.3% 98.7% 28 13% 99.1% 109 1.9% 98.9%

1000+ 70 0.1% 99.9% 44 1.3% 100.0% 14 0.7% 99.8% 58 1.0% 99.9%

Total 115,943 3,492 2,100 5,592

Source: IRS Statistics of Income, Individual Income Tax Returns 1994, Publ. 1304
(1997), Table 1.4, cols. (1), (73), and (75). Numbers do not add to 100% due to rounding.

The IRS statistics underlying the data set forth in Table 1 unfortu-
nately do not provide any indication of the filing status of the taxpayer filing
the return (single, joint, married filing separately, or head of household). It
may, however, be reasonable to assume that on average, 1994 returns report-
ing adjusted gross income below about $40,000 represented taxpayers in the
15% or lower marginal income tax bracket.9' Based on that assumption,

90. This category represents all returns with AGI greater than zero but less than
$5,000.

91. In 1994, married taxpayers with taxable income below $38,000 were in the 15%
bracket; for heads of household, the figure was $30,500; for single individuals, $22,750; for
married filing separate, $19,000. IRC § 1(a)-(d), (f). To estimate the average AGI cut-off point
for the 15% tax bracket, we first increased the taxable income amount for each category of
tax return filer by a personal exemption amount ($2,450 in 1994; two exemptions were
assumed for joint filers and heads of household) and the 1994 standard deduction (S6,350 for
joint filers, $5,600 for heads of household, $3,800 for singles, and S3,175 for married filing

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Florida Tax Review

Table 1 indicates that roughly 37.4% of the returns reporting partnership or
S corporation income or loss in 1994 were filed by taxpayers in the 15% or
lower tax bracket, and roughly 62.6% were filed by taxpayers in the 28% or
higher bracket. 92 In contrast, approximately 72.8% of all returns were filed
by taxpayers in the 15% or lower tax bracket, and approximately 27.2% were
filed by taxpayers in the 28% or higher bracket.93 Other data reveals that
about 13% of the returns reporting partnership or S corporation income or
loss were "nontaxable returns" reporting no income tax liability, and
therefore, the taxpayers filing them might be considered to have been in the
0% tax bracket.94 Putting all of this information together, a rough profile of
the individual taxpayers reporting partnership or S corporation income or loss
in 1994 is as follows:

marginal income % of all returns % of
tax bracket filed by individuals all returns

of tax return reporting K or S filed by
filer income or loss individuals

0 percent 13% not avail.
15 percent 24.4% not avail.
0 or 15 percent 37.4% 72.8%
28 percent or higher 62.6% 27.2%

separately). IRC §§ 63(c), 151(d). We then averaged the estimated AGI cut-off points in each
category for the 15% tax bracket ($49,250 for joint filers, $41,000 for heads of household,
$29,000 for singles, and $24,625 for married filing separately) based on the percentage of
filers in each category in 1994 (joint - 41.7%, head of household - 13.0%, single - 43.0%, and
married filing separately - 2.1%). See IRS Statistics of Income, Individual Income Tax Returns
1994, Publ. 1304 (1997) [hereinafter 1994 SOI Individual], Table 1.3, cols. (1), (3), (5), (7),
and (11), at 36-37. The result was an estimated, overall AGI cut-off in 1994 for the 15% tax
bracket of $38,854 ($49,250 x 41.7% + $41,000 x 13.0% + $29,000 x 43.0% + $24,625 x
2.1%). Because the minimum number of exemptions and the standard deduction were both
assumed, the actual figure would be higher than $38,854, hence the assumption of about
$40,000 in the text.

Another recent study has estimated that in 1994, there were approximately
25,562,000 returns filed by taxpayers in the 28% or higher tax bracket. See Therese M.
Cruciano, Individual Income Tax Rates and Tax Shares, 1994, 16 SOI Bulletin 7, 10 (Spring
1997) (figure C). Counting up from the bottom of column (2) of Table 1 indicates that the
break between the 15% and 28% tax brackets occurs somewhere between $40,000 and $50,000
of AGI.

92. Table 1, col. (13), line 8.
93. Table 1, col. (4), line 8.
94. 1994 SOI Individual, supra note 91, Table 1.4, cols. (73) and (75), at 44, and

pp. 126-27.

[VoL 4:3



The Future Taxation of Private Business Firms

Thus, as one might expect, individual participants in partnerships or
subchapter S corporations in 1994 were, on average, in higher income tax
brackets than tax return filers generally, with almost two-thirds of those
reporting K or S items belonging in the 28% tax bracket or higher. Neverthe-
less, there were a surprisingly high number of low-bracket K or S individual
participants as well. This conclusion might suggest that there would be ample
opportunity for income shifting between low- and high-bracket owners of a
private business firm. For a number of reasons, however, the figures probably
exaggerate the extent of that potential problem if the firm is limited to
individual owners.

For one thing, low-bracket taxpayers may pair up with one another
to participate in a common private business firm. Although pairing of that
sort would increase their overall participation rate in such ventures, it would
not create a significant concern of tax item shifting.

Second, the figures in Table 1 indicate the likely tax bracket of
partners and S corporation shareholders after their share of pass-through
income or loss is taken into account. But to evaluate the potential availability
of a shifting strategy from investment in a pass-through entity, the tax bracket
of the participants should be known before taking into account their share of
pass-through items. For example, two high-income partners might shelter
most or all of their income through losses generated by their two-person
partnership, thereby making them both appear to be low-bracket taxpayers
after such losses are taken into account. Yet that sheltering would not result
from an inappropriate shifting of tax items between high and low-bracket
taxpayers, nor would that outcome be possible under those facts. There is
some evidence in the data to support this explanation as one reason for the
surprisingly high level of participation shown by Table 1 of low-bracket
taxpayers in partnerships and S corporations.95

Third, a small number of low-bracket taxpayers reporting partnership
or S corporation income or loss in 1994 apparently were subject to the

95. Of those taxpayers reporting K or S net income, only 1.3% were in the SO AGI
class. In contrast, of those taxpayers reporting K or S net loss, 7.3% were in the $0 AGI class.
See Table 1, cols. (6) and (9), line 1. In addition, the amount of K or S net losses claimed by
taxpayers with $0 AGI represented almost 40% of all such losses claimed, whereas the amount
of K or S net income reported by taxpayers with $0 AGI represented less than 1% of all such
income reported. 1994 SOI Individual, supra note 91, Table 1.4, cols. (74) and (76). at 44.
These figures suggest that K and S losses helped to make some numbers of partners and S
shareholders appear to be low-bracket taxpayers even though before such losses are taken into
account, they may have been high-bracket taxpayers.

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Florida Tax Review

alternative minimum tax.96 Thus, their marginal income tax bracket was
either 26% or 28%, the minimum tax rates, rather than 15% or lower.97

Fourth, the figures in Table 1 only reflect participation in partnership
and S corporation ventures by number of returns filed. If participation is
measured by amount of net income reported, a different picture is revealed:

Table 2
Amount of Partnership or Subchapter S Net Income

Reported on Individual Income Tax Returns,
by AGI Class (1994)

(1)
AGI
Class

($000)

0
1-598

5-10
10-15
15-20
20-25
25-30
30-40
40-50
50-75
75-100
100-200
200-500
500-1,000
1,000 +
Total

(2)
K or S

Net Inc.
Reported

($ million)
$ 1,136

205
507
995

1,096
1,078
1,233
3,297
2,718
7,300
7,270

24,054
34,536
19,658
49,193

$154,277

(3)
% of Tot.
K or S
Net Inc.
Reported

0.7%
0.1%
0.3%
0.6%
0.7%
0.7%
0.8%
2.1%
1.8%
4.7%
4.7%

15.6%
22.4%
12.7%
31.9%

(4)
Cum %
of Col.

(3)

0.7%
0.8%
1.1%
1.7%
2.4%
3.1%
3.9%
6.0%
7.8%

12.5%
17.2%
32.8%
55.2%
67.9%
99.8%

Source: IRS Statistics of Income, Individual Income Tax Returns 1994, Publ. 1304
(1997), Table 1.4, col. (74). Col. (4) does not add to 100% due to rounding.

96. About 93,000 tax returns, or roughly 1.7% of all returns reporting partnership
or S corporation income or loss, had AGI of under $10,000 yet were "taxable returns" and
therefore reported income tax liability. See 1994 SOI Individual, supra note 91, Table 1.4,
cols. (73) and (75), at 44, and pp. 126-27. Because a taxpayer with AGI of less than $10,000
probably had no regular income tax liability, these returns were likely reporting minimum tax.

97. IRC § 55(b)(1)(A).
98. See supra note 90.

[Vol 4:3



The Future Taxation of Private Business Firns

Table 2 indicates that in 1994, only 6% of total partnership or subchapter S
net income reported on individual income tax returns was reported on returns
having AGI of less than $40,000, which we have assumed to represent a
rough proxy for taxpayers in the 15% or lower tax bracket." This figure
indicates that if partnerships and S corporations were utilized previously to
shift income from high- to low-bracket individual taxpayers, only a relatively
small amount of income was involved. Of course, the proposals contained in
this article might change that pattern in the future. Nevertheless, the figures
suggest that at least historically, such entities have not been widely employed
to shift income between high- and low-bracket individuals." °

Finally and perhaps most importantly, regardless of how many low-
bracket taxpayers have participated in partnerships and S corporations in the
past and might be expected to participate in an SPBF in the future, they are
able to shelter only a limited amount of income before higher brackets would
apply to them. The one exception would be a zero-bracket individual taxpayer
with a large net operating loss carryover, but that apparently is a fairly
uncommon situation.'' Thus, the transaction costs to design a tax shelter
involving low- and high-bracket individual taxpayers may be fairly high.
Many low-bracket taxpayers would have to be assembled before any
significant amount of income of the high-bracket taxpayers could be
sheltered. The transaction costs might be particularly high if one further
assumes that low-bracket taxpayers who truly have low incomes may be

99. Table 2, col. (4), line 8.
100. The same inference can be drawn from data appearing on Table 1. For each

AGI category greater than $0 and less than $40,000, roughly the same percentage of taxpayers
reported partnership or S corporation loss as reported partnership or S corporation income. See
Table 1, cols. (6) and (9), lines (2)-(8). If shifting strategies involving low-bracket individuals
had been widely utilized, one would expect to see greater percentages of the low AGI
categories reporting pass-through income rather than pass-through losses.

101. For 1994, only 431,277 individual income tax returns out of a total of almost
116 million filed, or about 0.4% of all individual returns, claimed a net operating loss
deduction for a loss arising in a prior taxable year. See 1994 SOI Individual, supra note 91,
Table 1.4, col. (97), at 46. (The term "net operating loss" used in the IRS tables refers to net
operating loss deductions claimed in 1994 for prior year losses, and not to net operating losses
arising in 1994 which may be carried back or forward to other years. See id. at 118-19.)

Although the claiming of an NOL deduction by an individual is therefore infrequent,
the amount of deduction claimed may be sizable. In 1994, a total of $47.045 billion in NOL
deductions for losses from prior years were claimed by individuals, or an average NOL
deduction of $109,000 per claim. See id., Table 1.4, col (98), at 46. One might speculate that
NOL deductions of individuals are naturally and quickly used up as the level of the
individual's income and loss fluctuates from year to year because individuals could not be
expected to suffer losses for an extended period of time. If this is true, then there may not be
a large pool of NOLs belonging to individuals which would be available to offset income from
a tax shelter investment. But we have as yet uncovered no data to support or refute this
speculation.

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Florida Tax Review

fairly hard to identify due to their relative lack of sophistication in financial
matters. 

10 2

All of the foregoing reasons support the conclusion that an SPBF
with only individuals as owners does not present significant opportunities for
income and loss shifting."0 3 Accordingly, a more relaxed set of tax operat-
ing rules for an SPBF is permissible in that situation.

b. Public Subchapter C Firms as Owners.-The picture
changes rather dramatically if public firms taxable under subchapter C are
also permitted to be owners of an SPBF. Many C corporations have net
operating losses, which means that they not only are in a zero marginal
income tax bracket but also may be able to shelter a significant amount of
income in a given year.

For example, in 1993, the latest year for which such data is available,
just slightly over one-half of the corporate income tax returns filed (other
than returns of S corporations, RICs and REITs) reported net income."
The C corporation returns without net income reported an aggregate loss of
over $127 billion, an average loss of over $136,000 for each C corporation
return without net income.105 Moreover, over 39% of the C corporation
returns with net income claimed a net operating loss deduction from a prior
year loss, with a total of over $45 billion in such deductions claimed.0 6

The foregoing information relates to income tax returns filed by both
public and closely-held C corporations. To estimate the likely NOL situations
of public C corporations, Table 3 provides data regarding the amount of
corporate NOL deductions claimed in 1993, broken down by the asset size
of the corporation whose return made the claim.

102. But see Boris I. Bittker, Tax Shelters for the Poor?, 51 Taxes 68 (1973)
(tongue-in-cheek description of partnership venture operating coin-operated washing and
vending machines in basement of low-income housing project, in which low-income tenant-
partners with "excess" personal exemptions and standard deductions are allocated pre-
depreciation income of venture and high-bracket investor-partners are allocated depreciation
deductions).

103. Again, this conclusion does not apply to possible shifts involving particular tax
items of the firm, such as capital gains and losses. That concern is addressed below.

104. Internal Revenue Service, 1993 Statistics of Income, Corporation Income Tax
Returns, Publ. 16 (1996) [hereinafter 1993 SOI Corporate], Table 18, col. (1). We treat the
category of corporate income tax returns other than S, RIC, or REIT returns as a proxy for C
corporation returns.

105. 1993 SOI Corporate, Table 18, cols. (1) and (2).
106. Id. Corporate net operating loss carrybacks to 1993 are not included in the IRS

statistics. See id. at 181. The fact that the C corporation losses reported in 1993 were almost
three times the amount of the net operating loss carryforwards deducted in 1993 may suggest
either a significant amount of NOL carrybacks not reflected in these statistics or large amounts
of unused NOLs.

[VoL 4:3



The Future Taxation of Private Business Firms

Table 3
Corporate NOL Deductions Claimed,

By Asset Size of Corporation Filing Return (1993)

(1) (2) (3)
Asset Size # corp. # rets.

rets. w/NOL
(O00s) ded.

(000s)
$0 239.3 20.93
$1-$100K 2,049.6 224.74
$100K-$250K 635.3 80.47
$250K-$500K 394.2 48.55
$50OK-$1M 269.3 28.91

$1M-$5M 279.1 27.54
$5M-$10M 40.1 3.97

$1OM-$25M 25.9 3.14
$25M-$50M 11.4 1.50

$50M-$100M 8.0 1.06
$10OM-$250M 6.6 .82
$250M + 6.8 1.12

Total 3,964.6 442.74

(4)
% rets.
w/NOL

ded.
(3)-(2)

8.7%
11.0%
12.7%

12.3%
10.7%
9.9%
9.9%

12.1%
13.2%
13.3%
12.4%
16.5%

11.2%

(5)
NOL.
ded.
(SM)

$ 1,773.4
2,085.5
1,470.0

1,305.7
1,496.4
3,420.6
1,294.9
2,075.4
1,771.0
2,276.0
2,629.4

23,560.7

$45,158.9

(6)
% of
Tot.
NOL
ded.
3.9%
4.6%
3.3%
2.9%
3.3%
7.6%
2.9%
4.6%
3.9%
5.0%
5.8%

52.2%

(7)
Avg. NOL

ded. per claim
(SCOs)
(5)Y(3)

S 84.7
9.3

18.3
26.9

51.8
124.2

326.2

661.0
1,180.7
2,147.2
3,206.6

21,036.3

$ 102.0

Source: Michael G. Seiders, Corporation Income Tax Returns, 1993, 16 SOl Bulletin 36,
51-54 (summer, 1996) (Table 2). Certain information was obtained from a telephone
conversation between John Comisky, economist at the Statistics of Income, and the
author. The data only reflects net operating losses carried forward to, and deducted in,
1993. Data concerning NOLs carried back to 1993 is not included.

According to Table 3, more than half of the corporate NOL
deductions in 1993 were claimed on returns for corporations with assets in
excess of $250 million, the largest asset size category available from IRS
statistics, and about 63% of those deductions were claimed on returns for
corporations with assets greater than $50 million.'07 Except for the initial
category of returns showing $0 assets, the average NOL deduction per claim
steadily increases with the size of the corporate claimant, with corporate
returns in the largest asset size category claiming an average NOL deduction
of over $21 million.' Moreover, these figures only reflect NOL deductions

107. Table 3, col. (6), lines 10-12.
108. Table 3, col. (7).

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Florida Tax Review

carried forward to 1993 from a prior taxable year."°9 Hence, the average
NOL carryforward and carryback deduction in 1993 was larger than these
numbers.

In 1993, there were 12,764 10-K forms filed with the SEC, an
indication of the number of domestic public corporations in existence in that
year."' Over 60% of those companies were listed on either the New York
Stock Exchange, the American Exchange, or the Nasdaq."' Data for
companies listed on the American Exchange in that year indicates a median
asset size of $58.3 million and a mean asset size of $330.4 million." 2

Nasdaq companies seem to have a similar profile, and New York Stock
Exchange companies appear to be larger. ' 3 Thus, as one might expect, it
would seem that public C corporations fall disproportionately among the
higher asset size categories listed in Table 3, the companies with the largest
average NOL deductions.

In light of the fact that net operating losses appear to be so prevalent
among subchapter C corporations generally, and that public C corporations
appear to have large pools of NOL deductions, allowing public firms to be
owners of an SPBF will significantly increase the chances that these entities
will be used to shift sizable amounts of income and loss around." 4 The
pools of losses provide potential sources for very deep tax shelters with
minimal transaction costs. Accordingly, public firms taxed under subchapter
C should be excluded from the ranks of owners of an SPBF.

109. See Michael G. Seiders, Corporation Income Tax Returns, 1993, 16 SOl
Bulletin 36, 42 (Summer, 1996).

110. Securities and Exchange Commission, Directory of Companies Required to File
Annual Reports with the Securities and Exchange Commission Under the Securities Exchange
Act of 1934 1 (Sept. 30, 1993).

111. The breakdown was 4,611 companies for Nasdaq, 2,362 for the New York
Stock Exchange, and 869 for the American Exchange, a total of 7,842 companies or about
61% of the 12,764 10-K forms filed. See Nasdaq Mkt Data web page (visited July 15, 1997)
<http://www.nasd.com/> [hereinafter Nasdaq web page]. The statement assumes that the same
company was not traded on more than one of the exchanges.

112. American Stock Exchange, 1994 Fact Book: Equities and Derivative Securities
Covering the 1993 Market 16 (1994).

113. For 1997, Nasdaq reported that the average asset size of its companies was just
under $500 million, almost exactly the same average reported by the American Exchange for
that year. See Nasdaq web page, supra note 111; letter from Scott Slatin, Equity Research and
Development, American Stock Exchange, to Peirce Moser (Aug. 6, 1997) (electronically
transmitted) (on file with author). In 1994 and since 1988, to be listed on the New York Stock
Exchange, a company had to have a minimum of $18 million in assets. New York Stock
Exchange, Fact Book for the Year 1994, p. 35 (1995).

114. Cf. Richard G. Cohen & Lori S. Hoberman, Partnership Taxation: Changes for
the '90s, 71 Taxes 882, 883 (1993).

[Vol 4:3



The Future Taxation of Private Business Finns

c. Other Possible Owners.-In addition to corporations, the
subchapter S rules prohibit most other entities from being owners.'"
Clearly, for reasons described above, a private business firm with a public
firm owner should not be an eligible SPBF owner. To maintain simplicity and
to protect the one class of residual ownership interests rule (described below),
most other entities should also be excluded as eligible owners. Exceptions are
provided for estates and certain trusts that qualify under current law as an
eligible shareholder of an S corporation." 6 As under current law, however,
a qualifying trust may not have as a beneficiary any person who is ineligible
to be an owner of an SPBF."' An SPBF may also have another SPBF as
an owner. Thus, for example, a professional partnership some of whose
partners are single-member LLCs would satisfy the ownership requirement
for an SPBF if the LLC partners themselves qualify as SPBFs.

Congress recently allowed tax-exempt qualified retirement plans
under section 401(a) and charitable organizations under section 501(c)(3) to
qualify as shareholders of an S corporation so long as the tax-exempt entity's
share of S income is taxable as unrelated business income."' According to
the Senate report-

... the present-law prohibition of certain tax-exempt organizations
being S corporation shareholders may inhibit employee ownership of
closely-held businesses, frustrate estate planning, discourage charita-
ble giving, and restrict sources of capital for closely-held businesses.
The Committee seeks to lift these barriers by allowing certain tax-
exempt organizations to be shareholders in S corporations. However,
the provisions of subchapter S were enacted in 1958 and substantially
modified in 1982 on the premise that all income of the S corporation
(including all gains on the sale of the stock) would be subject to a
shareholder-level income tax. This underlying premise allows the
rules governing S corporations to be relatively simple (in contrast, for
example, to the partnership rules of subchapter K) because of the
lack of concern about "transferring" income to non-taxpaying
persons. Consistent with this underlying premise of subchapter S, the

115. IRC § 1361(b)(1)(B).
116. IRC § 1361(c)(2).
117. IRC § 1361(e)(1)(A).
118. IRC §§ 1361(c)(6) and 512(e), added by the Small Business Job Protection Act

of 1996. But see IRC § 512(e)(3), added by the 1997 Act, which repealed the application of
the unrelated business income tax to ESOPs that are S corporation shareholders. See Martin
D. Ginsburg, The Taxpayer Relief Act of 1997: Worse Than You Think, 76 Tax Notes 1790
(1997) (demonstrating how § 512(e)(3) may operate to exempt from tax all of the income of
an S corporation for an extended period of time).

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Florida Tax Review

provision treats all the income flowing through to a tax-exempt
shareholder, and gains and losses from the disposition of the stock,
as unrelated business taxable income."9

The Senate report evidences a desire to increase the flexibility and utility of
subchapter S while, at the same time, preserving its relatively simple
operating rule structure. These are exactly the same two objectives for an
SPBF. However, in contrast to the Congressional decision in 1996, this article
concludes that on balance, it would be preferable to exclude such entities as
owners, as was the case for subchapter S prior to 1996.

First, allowing such entities to be owners of an SPBF, and taxing
them on their share of business income, increases the complexity of the rule
structure. 2 Although the flexibility of an SPBF is increased slightly by
permitting such owners, it comes with a high price.

Furthermore, there is a simple alternative to permitting exempt
owners of an SPBF. If it is truly critical for an exempt entity to participate
in a common business venture organized as an SPBF, the taxpayers could
form a non-SPBF partnership or other private enterprise taxable as a conduit,
with the owners of such entity being the SPBF and the exempt partner.'2 1

Thus, the business necessity of allowing an exempt entity to be an SPBF
owner is far from clear.

Finally, taxing exempt entities on their share of SPBF business
income may not eliminate the shifting concerns so central to preserving the
simple rule structure applicable to an SPBF. Table 4 provides data on the

119. S. Rep. No. 281, 104th Cong., 2d Sess. 60-61 (1996), reprinted in 1996
U.S.C.C.A.N. 1474, 1534-35.

120. The peculiar complexities of subchapter K have already started to creep into
subchapter S as a result of this 1996 change. Section 170(e)(1) of the Code, as amended by
§ 1316(b) of Pub. L. No. 104-188, 110 Stat. 1755 (1996), says that when stock of an S
corporation is contributed to a charity, "rules similar to the rules of § 751 shall apply in
determining whether gain on such stock would have been long-term capital gain if such stock
were sold by the taxpayer." In other words, on the occasion of such a contribution, an analysis
of the S corporation's assets will have to be made to determine what percentage of them are
unrealized receivables and inventory. See generally Testimony of Martin D. Ginsburg,
professor of law, Georgetown University Law Center, before the Subcommittee on Taxation
of the Senate Finance Committee on S. 758, the S Corporation Reform Act of 1995, 95 TNT
119-19 (June 20, 1995) (LEXIS, FEDTAX library, TNT file) ("the proposal to allow as S
corporation shareholders tax-exempt organizations and nonresident aliens is I think unwise.
Inevitably, it must add significant complexity to a tax regime a principal justification for which
is its relative simplicity in operation"); Small-Business Bill's Subchapter S Provisions Will
Spawn More Regs., 72 Tax Notes 965 (Aug. 19, 1996) (rule allowing charities and ESOPs to
be eligible S corporation shareholders will cause lengthy IRS regulations project).

121. See Regs. § 1.701-2(d), ex. 2, which explicitly blesses this type of
arrangement.

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The Future Taxation of Private Business Firms

unrelated business income and loss reported by section 501(c)(3), section
401(a), and all tax-exempt organizations in 1993, the latest year for which
such data is available. Table 5 then provides data on the net operating loss
deductions claimed by such organizations in that year.

Table 4
Unrelated Business (UB) Income and Loss

Reported by Section 501(c)(3), Section 401(a),
and All Tax-Exempt Organizations (1993)

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Type of # rets. # w/ %w/ #w/ %w/ # w/ %w/ Tot. Avg. loss
exempt w/UB pos. UB pos. UB $0 UB $0 UB UB UB loss per loss

org. inc.loss inc. inc. inc. inc. loss loss (S ail) org.
(3)-+(2) (5)+,(2) (7)-.(2) (9Y+-(7)

501(c)(3) 9,246 3,191 34.5% 1,204 13.0% 4,851 52.5% 1,001.6 S206.473

401(a) 1,135 718 63.3% 163 14.4% 254 22.4% 19.4 76.378

All 32,638 15,067 46.2% 4,805 14.7% 12,766 39.1% 1,650.8 129,312

Source: Margaret Riley, Exempt Organization Business Income Tax Returns: Highlights
and an Analysis of Exempt and Nonexempt Finances, 1993, 16 SOl Bulletin 75, 91-92
(spring 1997) (Tables 1 and 3). Certain information was obtained directly from Ms. Riley,
a statistician in the Special Studies and Publications Branch, Statistics of Income.

Table 5
NOL Deductions Claimed By Section 501(c)(3),

Section 401(a), and All Tax-Exempt Organizations
Reporting Unrelated Business (UB) Income or Loss (1993)

(1) (2) (3) (4) (5) (6)
Type of # Rets. # Rets. % Rets. NOL Avg. NOL
exempt wI UB w/NOL w/NOL ded. ded. per

org. inc./loss ded. ded. (S M) claim
(3)-(2) (5)-(3)

501(c)(3) 9,246 2,516 27.2% $ 783.3 $311,328

401(a) 1,135 313 27.6% 17.8 56,869

All 32,638 6,844 21.0% $1,342.8 $196,201

Source: Margaret Riley, Exempt Organization Business Income Tax Returns: Highlights
and an Analysis of Exempt and Nonexempt Finances, 1993, 16 SOI Bulletin 75, 91, 97-98
(spring 1997) (Tables 1 and 7). Certain information was obtained directly from Ms. Riley.
The data only reflects net operating losses carried forward to, and deducted in, 1993. Data
concerning NOLs caried back to 1993 is not included.

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According to Table 4, almost two-thirds of the section 501(c)(3)
organizations reporting unrelated business income or loss in 1993 reported
either zero income or a net loss for the year.'22 Over half of them reported
a net loss, with an average loss per section 501(c)(3) "loss" organization of
over $200,000. 123 The total loss reported by such organizations was just
over $1 billion. 24 Table 5 indicates that more than one-fourth of all section
501(c)(3) organizations reporting unrelated business income or loss claimed
a net operating loss deduction from a prior year loss in 1993, with an average
NOL deduction per claim of over $300,000."' 5 About $783 million in such
NOL deductions were claimed in that year. 126

These figures suggest that the tax profile of section 501(c)(3)
organizations involved in unrelated business activities may not be markedly
different from that of public C corporations. A substantial number of section
501(c)(3) organizations report either no income or losses for tax purposes
from their unrelated activities, and although their average claimed NOL
deduction is small in comparison with the average NOL deductions of the
largest taxable corporations, the deductions are nevertheless significant in
size. 27 Like their corporate counterpart, those deductions could provide
ample shelter opportunities in any given case.

Perhaps these conclusions should not be surprising; after all, if an
exempt organization is taxed on its unrelated business activities in the same
manner as a taxable corporation, then one might expect a similar resulting tax
profile to those corporations. Indeed, some have suggested that the tax rules
for computing unrelated business taxable income are more favorable than for
calculating taxable income generally because the former may allow the
deduction against unrelated business income of expenses attributable to the
exempt function of the organization. 2' Obviously, the more favorable the

122. Table 4, cols. (6) and (8), line 1.
123. Table 4, cols. (8) and (10), line 1.
124. Table 4, col. (9), line 1.
125. Table 5, cols. (4) and (6), line 1.
126. Table 5, col. (5), line 1.
127. Compare Table 3, col. (7), lines 10-12 with Table 5, col. (6), line 1. In

addition, just like the other data on NOL deductions, the figures in Table 5 do not include loss
carrybacks to 1993. See Margaret Riley, Exempt Organization Business Income Tax Returns:
Highlights and an Analysis of Exempt and Nonexempt Finances, 1993, 16 SOI Bulletin 75,
84 (Spring, 1997). Thus, the actual NOL deductions of exempt organizations are larger than
the numbers shown in columns (5) and (6) of Table 5.

128. See U.S. House Ways and Means Oversight Subcommittee UBIT Recommen-
dations (draft), reprinted in 88 TNT 132-5 (Jun. 24, 1988) (LEXIS, FEDTAX library, TNT
file) ("there has been evidence of excessive, and in some cases possibly abusive, allocations
to taxable uses of various expenses ... attributable to [facilities used for both exempt and
nonexempt purposes]. In these cases, net income from taxable activities may be greatly
reduced or completely eliminated simply through liberal expense allocations."). For additional

[Vol. 4:3



The Future Taxation of Private Business Firms

tax rules, the greater the possibility of generating losses for tax purposes. In
any event, whatever the explanation, it would seem that for the same reasons
that public C firms are excluded as owners of an SPBF, section 501(c)(3)
organizations should also be excluded.' 29

The case for excluding taxpayers qualifying under section 401(a) is
less clear. As shown on Tables 4 and 5, fewer of them than section 501(c)(3)
organizations report losses, and the average amount of losses reported and net
operating loss deductions claimed is much less.' On the other hand, the
issue of permitting them to be an SPBF owner may not be very significant,
as only 1,135 section 401(a) organizations reported any unrelated business
income or loss at all in 1993, 13 and just a fraction of them reported income
from partnerships and therefore might be expected to be potential owners of
an SPBF in the future. 13 Therefore, for the other reasons stated above, it
seems preferable to exclude them as owners as well.

In summary, exempt entities are treated like almost all other entities
and are excluded from ownership of an SPBF.

Much the same reasoning supports excluding nonresident aliens as
owners of an SPBF. Ascribing the firm's activities to the nonresident alien,
as in the case of a foreign partner in a partnership or a foreign beneficiary of
a trust or estate engaged in a trade or business in the United States,'33

thereby creating a trade or business in the United States for the foreigner and
serving as a basis for taxing the foreign person on the U.S. profits of the
enterprise, would add complexity to the SPBF structure. There would also be
the administrative problem of collecting any resulting tax on undistributed
income from the foreign person."l In addition, the business necessity of

discussion of this issue, see John Copeland & Gabriel Rudney, Business Income of Nonprofits
and Competitive Advantage, 33 Tax Notes 747, 752-53 (1986); Thomas A. Troyer, Changing
UBIT: Congress in the Workshop, 41 Tax Notes 1221, 1224 (1988).

129. The charities reporting unrelated business income or loss are, of course, just
a small fraction of the roughly 500,000 nonprofit charitable organizations recognized by the
IRS under § 501(c)(3). But the tax profile of that small subset of charities is very relevant to
this analysis. The most likely charities to own an SPBF in the future, if the rules allow it, are
those that have previously served as partners in partnerships, and therefore have received and
reported unrelated business income.

130. See Table 4, cols. (8) and (10), compare lines 1 and 2; Table 5, col. (6),
compare lines 1 and 2.

131. See Table 4, col. (2), line 2.
132. Only 2,690 exempt organizations out of the 32,638 reporting any unrelated

business activities in 1993, about 8%, reported income or loss from partnerships. See Riley,
supra note 127, at 95 (Table 6, coL (11)).

133. IRC § 875(1) and (2).
134. Section 1446(a) requires a partnership with effectively connected income and

a foreign partner to pay a withholding tax on the portion of such income allocable to the
foreign partner. The withholding tax obligation arises regardless of whether there is any

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Florida Tax Review

permitting foreigners to own an SPBF is not clear, in view of the alternative
means available to accomplish that investment objective.'35 Finally, a
foreigner who is in a low U.S. income tax bracket may nevertheless be a
"high-bracket" taxpayer if worldwide income is considered, in which case
assumptions regarding the lack of financial sophistication of such a taxpayer
would be inapplicable. For these reasons, as is true for existing subchapter S,
nonresident aliens are excluded as eligible owners of an SPBF.'36

d. Summary.-In summary, individuals other than nonresi-
dent aliens may be owners of an SPBF. The only other permissible owners
are estates, trusts that are allowed to be shareholders of an S corporation
under current law, and other SPBF firms. Public firms taxed under subchapter
C may not be owners of an SPBF.

2. Only One Class of Residual Ownership Interests.-Although the
ownership restrictions for an SPBF are designed to insure that most owners
have roughly the same tax profile and therefore cannot easily benefit from
income and loss shifts between one another, such rules are not effective at
precluding strategic shifts of categories of income and loss and other tax
items. For example, two high-bracket owners would not ordinarily benefit
from shifting ordinary income from one to the other. But if one owner had
unused capital losses and the other did not, the two owners might both
benefit from a shift of capital gains to the owner with the capital losses.

The availability of strategic shifts involving particular categories of
tax items is limited, however, if all ownership interests of an SPBF have
identical rights to income, loss, distributions, and liquidation proceeds of the
firm and the allocation of all tax items has to be done in the same straight-up
manner in accordance with the per-day, per-interest share of each owner."'
In effect, such a rule eliminates the possibility of item allocations. All tax
items would have to be allocated in the same way. Thus, a one-class-of-
ownership-interest rule may be a useful complement to the ownership
restrictions of an SPBF to restrict the availability of shifting strategies within
an SPBF.

Another reason to include such a requirement is to reduce the
complexity of the SPBF operating rules. The one-class-of-stock rule in the

distribution to the foreign partner and whether the partnership's income is reflected in cash.
The provision, enacted in 1986, requires the tax to be paid in accordance with Treasury
regulations, which to date, have not been issued.

135. See supra note 121 and accompanying text.
136. A proposal to make them eligible was not included in the Small Business Job

Protection Act of 1996.
137. Cf. Regs. § 1.1361-1(0(1).

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The Future Taxation of Private Business Firms

subchapter S area has been explained as "prevent[ing] complexities in
attributing the corporate distributions to the various shareholders."'33, Those
complexities certainly do exist in the rules applied to partnerships, trusts and
consolidated groups, none of which imposes restrictions on ownership classes.
As just one example, the partnership rules contain strict and extensive
requirements regarding the maintenance of the capital accounts of the partners
in order to validate the special allocations of the partners, whereas the S
corporation rules have no comparable requirement. In the ideal, the SPBF
rules would not require owners of the firm to maintain capital accounts in any
particular way.

On the other hand, if the SPBF eligibility conditions are too
restrictive, they would be contrary to the objective of providing a simplified
rule structure to as many private business firms as possible. Thus, it is not
clear that an SPBF would have to have only a single class of ownership
interests as that concept is interpreted under existing subchapter S.

Consider, for example, two taxpayers, A and B, who decide to
contribute $5,000 each to a common business venture. A would like a
relatively certain and safe return on his or her investment with the under-
standing that there will be little or no upside potential beyond that safe return.
B is willing to go along with A's request and to assume the risk of all losses
beyond the amounts contributed so long as B will garner all of the upside
potential in excess of the return belonging to A. Under current law, the two
investors can utilize an S corporation only if A's investment is treated as debt
rather than equity.139 If, for good business reasons such as the insistence of
a third-party lender to the firm, a loan from A is not feasible, then an S
corporation cannot accommodate them; they would have to form a partnership
or other unincorporated entity and be taxed under subchapter K."o

138. Barnes Motor & Parts Co. v. United States, 309 F. Supp. 298, 301 (ED. N.C.
1970); see also Paige v. United States, 580 F.2d 960, 963-64 (9th Cir. 1978). The Barnes
opinion suggests that all the restrictions in § 1361(b)(1) can be explained on this basis. That
includes the number of shareholders, the prohibition of a shareholder who is not an individual,
and the prohibition of a nonresident alien shareholder. See also supra note 83.

139. See IRC § 1361(c)(5) (straight debt not considered second class of stock).
140. The granting of compensatory options to shareholder-employees of the S

corporation is one way of achieving some flexibility within the constraints of the S
corporation's one-class-of-stock rule. See James S. Eustice & Joel D. Kuntz, Federal Income
Taxation of S Corporations 6.04 (3d ed. 1993); Berger, supra note 63, at 141. The
regulations specifically bless certain forms of such options. See Regs. § 1.1361-
1(/(4)(ii)(B)(2). On the other hand, the regulations indicate that if the State Corporation
Commissioner imposes a restriction on the distribution rights of certain shareholders, the
restriction may constitute a second class of ownership and therefore prevent qualification as
an S corporation. See Regs. § 1.1361-1(/)(2)(v), ex. (1); Paige v. United States, 580 F.2d 960
(9th Cir. 1978). Permitting the firm to issue a class of straight preferred ownership interests
would overcome that obstacle.

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Florida Tax Review

One method of accommodating the foregoing business arrangement
would be to allow the entity to issue the equivalent of plain vanilla preferred
stock. 4 ' The proposal would permit a class of ownership interests to be
issued with a clear priority over the only other class of interests, and return
on the preferred class would be fixed and limited to the earnings of the
entity. In the foregoing example, A might own all of the preferred interests
and be allocated the first slice of entity income. B would own all of the
remaining, residual interests, and be allocated any losses of the firm and all
income beyond the initial slice belonging to A.

Could the existence of two classes of ownership interests, one with
clear income priority over the other, be manipulated by the parties? One
possible concern might be the "skimming" of income to part-year owners.
Consider a calendar year firm that issues a new class of preferred interests on
December 31. If there is nothing to limit the amount of income that could be
allocated to the one-day owner of the preferred interest, the newly-issued
interest would allow manipulation of the firm's income for the year. In an
extreme case, the preference could be such that all of the firm's income for
the year would be allocated to the new owner and away from the holders of
the residual interests. 42

But a similar problem arises under existing subchapter S and, as a
result, section 1377 requires the firm to divide up its income pro rata among
the days of the year. Thus, one who acquires all of the stock in an S
corporation under existing law on the last day of the year cannot be allocated
all of the corporation's income for the year. As long as the preferred class of
ownership interests is restricted in the same way, the possibility of manipula-
tion from such a maneuver appears to be reduced or eliminated.4 3

141. Such a proposal was included in the "S Corporation Reform Act of 1995," S.
758, reproduced at 95 TNT 88-5 (May 5, 1995), § 121 (LEXIS, FEDTAX library, TNT file).
However, it was not part of the subchapter S liberalizations contained in the Small Business
Job Protection Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755 (1996).

142. The "S Corporation Reform Act of 1995," S. 758, reproduced at 95 TNT 88-5
(May 5, 1995) (LEXIS, FEDTAX library, TNT file), as drafted, appears to have allowed for
such manipulation. It would have added § 1361(c)(8) to the Code, under which distributions
on qualified preferred stock (stock described in § 1504(a)(4)) would have been treated as
interest payments. There is no indication that the holder of the stock on the record date would
not have been credited with the full amount of interest no matter how short a time period the
stock had been held. In any event, this provision did not become part of the Small Business
Job Protection Act of 1996.

143. Income of the entity would first be allocated to each day of the taxable year.
Hence, if an owner acquires all of the preferred interests on the last day of the year, that
owner can get allocated at most all of the income of the entity allocated to that day. That
result would occur no matter how great the preference of the ownership interest. At most, an
interest with a large preference could be allocated all the firm's income earned for the year
properly allocable to the period that the interest was outstanding.

[Vol 4:3



The Future Taxation of Private Business Firms

Other concerns relate to the character of income allocated to the
preference holder. For example, suppose A is provided a preferential interest
equal to the first $1,000 of the firm's income, with any additional income and
all losses to be shared equally by A and B. Suppose during the year, the firm
has only $1,200 of capital gain income, a fact reasonably known to the
parties at the time the preferential interest was created. Should A's preference
then mean that A is allocated $1,100 and B $100 of the firm's capital gains
for the year? If so, it is evident that the strategic utilization of preferential
interests could easily permit the equivalent of special item allocations.'"

To avoid such possibilities and to be consistent with the "debt-like"
characterization of the preferred interest, any income allocated to the
preference holder should be treated as ordinary income with the firm being
provided with an ordinary deduction.' The preference should not in any
other respect affect the amount or character of tax items allocated to the
owners of the firm." Thus, in the above example, A would be allocated
$1,000 of ordinary income and would share equally with B in the $1,200 of
capital gain and the $1,000 ordinary deduction of the firm. The tax result
would be the same as if A had loaned funds to the firm and been entitled to
a $1,000 interest payment that year.

If the firm has enough income to support the preference but does not
distribute the full preferred amount, one possible rule would be to defer the
tax consequences of the unpaid amount until paymenL' 47 Alternatively, the

144. Moreover, if the firm had, say, $1,200 of capital gains and S800 of ordinary
income for the year, what should be the character of A's income preference?

145. Section 201 of S. 758, the "S Corporation Reform Act of 1995," supra note
141, would have imposed this requirement with respect to its qualifying preferred stock
interest.

146. Id. at § 201(b)(2) (holders of preferred stock not allocated any of the S
corporation's § 1366(a)(1) items).

147. This treatment would be consistent with an idea long advocated by Professor
Eustice in connection with subchapter S. Professor Eustice would permit an S corporation to
have a single class of common stock and any number of classes of preferred stock, including
participating preferred (which he would treat as preferred stock, and not common, in his
allocation scheme). Dividends actually paid on the preferred stock would be taxable as
ordinary income to the shareholders without regard to the corporation's earnings or profits or
other indication of income, and the corporation would be allowed to deduct the amount of
dividends actually paid. Thus, he would place both shareholders and the corporation on the
cash method of accounting with respect to dividends. The corporate dividends-paid deduction
could not, however, create a loss; the excess of such a deduction over corporate income would
have to be carried forward within the entity. Other losses and any remaining income of the
firm would be passed through to the common shareholders on a per-day, per-share basis. See
James S. Eustice, Subchapter S Corporations and Partnerships: A Search for the Pass Through
Paradigm (Some Preliminary Proposals), 39 Tax L. Rev. 345, 366 (1984) (a single class of
preferred stock); Eustice & Kuntz, supra note 140, at 1.0312][b][v] (multiple classes); see
also Berger, supra note 63, at 141 (endorses Eustice and Kuntz proposal); ABA Section of

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Florida Tax Review

allocation of ordinary income (with accompanying ordinary deduction for the
firm) might take place in the current year, as would generally be true in the
case of a deferred payment of interest. 48 In that case, if the preference is
not satisfied by the time the holder terminates his or her investment in the
firm, then the tax treatment would be the same as cancellation of a debt
obligation-the preference holder would be entitled at that time to a bad debt
deduction and the firm would have cancellation of indebtedness income.

Other possible manipulative uses of a preferred interest would be
mitigated by the ownership restrictions of an SPBF. Suppose, for example,
that preferred interests and residual interests of the same firm could be
exchanged tax-free, either directly in a tax-free recapitalization or indirectly
through a combination of contributions and distributions. The special
allocation rules in the partnership area basically permit tax-free exchanges
because allocations can be changed from one year to the next without tax
consequences. Ordinarily, if investors A and B could change their positions
as preferred and residual interest holders from one year to the next without
tax consequences, then important tax advantages might result. But the extent
of the advantage would depend upon how different the investors' tax profiles
are, something the ownership restrictions are designed to restrict.

In summary, the proposal merely limits an SPBF to having only one
class of residual ownership interests. Every outstanding interest in the
residual class must confer identical rights with respect to income, loss,
distributions, and liquidation proceeds of the firm. Multiple classes of
preferred interests are permissible provided that a clear order of priority for
the different preferred interests is established. All preferences should
constitute ordinary income to the preference holder and generate an ordinary
deduction to the firm. Any income of the firm not allocable to the preferred
interests, and all losses of the firm, are allocable to the class of residual
interest holders in a proportional manner based on their percentage interests
and the number of days in the year they owned such interests.

3. Other Eligibility Conditions Not Proposed.-Several other
possible eligibility conditions for an SPBF were considered in addition to, or
in some cases as substitutes for, the ones described above. This section
briefly describes why they are not included in the proposal.

Taxation Committee on S Corporations, Report on the Comparison of S Corporations and
Partnerships (Part I), 44 Tax Law. 483, 494 (1991) (single class of stock requirement should
be altered).

148. See IRC § 1272(a). Similarly, a guaranteed payment which is deducted or
capitalized by a partnership must be included currently in the income of a cash-basis partner
even though the amount is unpaid. See William S. McKee, William F. Nelson & Robert L.
Whitmire, Federal Taxation of Partnerships and Partners 13.03[2] (3d ed. 1997).

[Vol 4:3



The Future Taxation of Private Business Firms

a. Number of Owners.-There is no restriction on the
number of permissible owners for a partnership, RIC, REIT, REMIC, FASIT
or cooperative. 49 In contrast, an S corporation may not have more than 75
shareholders.5 0 The IRS has indicated that the purpose of the limitation on
the number of shareholders of an S corporation is "administrative simplicity
in the administration of the corporation's tax affairs."'' The Service has
nevertheless allowed a number of S corporations to join together in a
partnership even though that arrangement could be viewed as a way to avoid
the limitation on the number of shareholders in an S corporation (and, indeed,
was so viewed by the IRS at one time).152

A major source of complexity in subchapter K is the allocation rules
which attempt to prevent the inappropriate shifting of tax items among
owners of a firm. In contrast to the eligibility conditions for an SPBF already
identified, it does not appear that the availability of shifting strategies is
affected by the number of participants in the enterprise. True, the greater the
number of owners, the greater the potential that taxpayers with distinctly
different tax profiles will participate together in a common venture. But
important tax advantages may exist even though a firm has only two owners.
And the fewer the number of owners, the greater the flexibility in devising
an advantageous shifting strategy.

Moreover, as a practical matter, very few private businesses have a
large number of owners. For example, in 1994, over 90% of all partnerships
and almost 99% of all S corporations had 10 or fewer owners,' 3 and
comparable figures seem likely for closely-held C corporations. Thus, any
reasonable limitation on number of owners would not likely have much
impact on SPBF eligibility."s

149. A FASIT may have only one holder of its ownership interest but any number
of holders of its regular interests. IRC § 860L(a)(1)(B) and (C).

150. IRC § 1361(b)(1)(A), as amended by the Small Business Job Protection Act
of 1996.

151. Rev. Rul. 94-43, 1994-2 C.B. 198.
152. Id.; cf. Regs. § 1.701-2(d), ex. (2) (blessing partnership between nonresident

alien and S corporation to avoid restrictions of § 1361(b)(I)(C)). The Service's prior contrary
position was stated in Rev. Rul. 77-220, 1977-1 C.B. 263.

153. In 1994, about 68% of all partnerships and 90% of all S corporations had three
or fewer owners. For the S corporation data, see Susan M. Wittman, S Corporation Returns,
1994, 16 SOI Bulletin 38,74 (Spring 1997) (Table 5). The information about partnerships was
obtained in a telephone conversation between the author and Mr. Tim Wheeler, a statistician
in the Corporation Special Projects Section, Statistics of Income, Internal Revenue Service.

154. Congress's recent amendment of the subchapter S rule provides no guidance
regarding what the proper limit on the number of owners should be, assuming one is imposed.
Congress tersely explained its reasons for increasing the allowable number of S shareholders
from 35 to 75 in the following way: "The Committee believes that increasing the maximum
number of shareholders of an S corporation will facilitate corporate ownership by additional

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Florida Tax Review

In short, any limitation on the permissible number of owners of an
SPBF would seem to be an arbitrary and ineffectual restriction insufficiently
linked to the availability of potential tax advantages of such a firm, and is
therefore not proposed.

b. Ownership of Other Entities.-Until recently, the S
corporation rules prohibited an S corporation from being part of an affiliated
group 55 Since S corporations may not have corporate owners, the major
effect of this rule was that S corporations could not own more than 80% of
the stock of another corporation (unless it was an inactive corporation). On
the other hand, S corporations were permitted to be partners in partnerships,
to be members of cooperatives, and to own stock in RICs and REITs. The
restrictions on stock ownership by S corporations have now been repealed,
although S corporations are prohibited from filing consolidated returns.'56

S corporations are now also allowed to be 100% owners of other S corpora-
tions, which are then not treated as separate entities. 57

RICs and REITs are limited in the amount of their assets that can be
invested in particular companies.15  The rules applicable to RICs and
REITs, however, are not functions of the conduit nature of those entities.
Rather, they relate to their roles as investment vehicles for relatively small
investors, and a securities law concern that such vehicles be sufficiently
diversified so as not to be too risky for such investors.'59 Consistent with
Congress's recent change regarding S corporations, there does not seem to be
any reason to impose any restrictions on the particular type of entity an SPBF
may own.

c. Nature of Income.-Eligibility for certain pass-through
entity regimes under current law is conditioned on the nature of the firm's
income or business activities. But the significance of a firm's passive or

family members, employees and capital investors." S. Rep. No. 281, 104th Cong., 2d Sess. 45
(1996), reprinted in 1996 U.S.C.C.A.N. 1474, 1519. Congress's reasoning may justify a
number greater than 35, but doesn't explain the reason for stopping at 75.

155. See former IRC § 1361(b)(2)(A), repealed by the Small Business Job
Protection Act of 1996, Pub. L. No. 104-188, § 1308(a).

156. See IRC § 1504(b)(8), added by the Small Business Job Protection Act of
1996, Pub. L. No. 104-188, § 1308(d)(2) (excepts S corporations from the definition of
"includible corporation"). This change tracks a suggestion made by Professor Eustice. See
Eustice, supra note 147, at 360.

157. See IRC § 1361(b)(3), added by the Small Business Job Protection Act of
1996, Pub. L. No. 104-188, § 1308(b).

158. See IRC §§ 851(b)(4) and 856(c)(5)(B).
159. The relevant provisions are referred to as diversification of investment

requirements. See Regs. §§ 1.851-2(c) and 1.856-2(d).

[Vol 4:3



The Future Taxation of Private Business Firms

active income or business activity is not coherent across the different tax
regimes. For a trust to be classified as such, it cannot be engaged in an active
business. In the past, failure to qualify as a trust would probably have
doomed the trust to be taxed as a corporation, but that is no longer true under
the check-the-box classification regulations."6 On the other hand, S
corporations with earnings and profits from their operations as C corporations
are currently subject to tax if they have excessive passive income.161

Most income of RICs must come from investment sources,' 62 and
the income of REITs must come substantially from real estate investments
that must be relatively passive in nature." REMICs are generally limited
to holding mortgages and other passive investments,'(' and FASITs are
similarly limited to certain short-term debt instruments. 65 Partnerships
generally have no limitation on the type of income that they can earn, except
that partnerships with publicly traded ownership interests escape corporate
classification if 90% or more of their gross income consists of certain
categories of "qualifying income."'"

160. Although the former classification regulations provided that an entity that failed
trust classification could be classified as either a partnership or an association, see former
Regs. § 301.7701-4(b), the four factor test usually resulted in entities formed as trusts being
classified as corporations. Trusts would generally have limited liability, free transferability of
interests, and centralized management, and would be classified as associations with those three
corporate characteristics. The check-the-box regulations treat failed trusts as "business entities."
and therefore permit them to make an explicit entity classification election for tax purposes.
See Regs. § 301.7701-4(b).

161. See IRC § 1375.
162. IRC § 851(b)(2) provides that at least 90% of the gross income of a RIC for

any taxable year must be from dividends, interest, payments with respect to security loans, and
gains from the sale of stocks, securities, foreign currency, or other investment income. Since
failure to satisfy this requirement would cause the RIC to be disqualified, the management of
a RIC is likely to stay comfortably above the 90% line. RICs are subject to additional
restrictions, including those relating to the assets they hold, see IRC § 851(b)(4), as well as
restrictions imposed on them so that they can comply with the Investment Company Act of
1940.

163. The income restrictions applicable to REITs can be found in IRC § 856(c)(2)
and (3). Key to the limitation on the REIT income are the restrictions applicable to "rents from
real property" that are found in IRC § 856(d). Excluded from "rents from real property" are
rents that are based on a tenant's income or profits, and rents received when the REIT (as
opposed to an independent manager) provides services to the tenants or runs the property, see
IRC §§ 856(d)(2)(A), (C).

164. See IRC §§ 860D(4) and 860G(a)(3) and (5).
165. See IRC §§ 860L(a)(1)(D), (c)(1).
166. See IRC § 7704(c)(1). "Qualifying income" is generally passive-type income

although it also includes certain potentially active income from businesses engaged in the
extractive industries. See IRC § 7704(d)(1).

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Florida Tax Review

As can be seen from the foregoing brief review, there are contradicto-
ry views of the importance of passive or active income or business activities
in the context of pass-through entities. Do the various conditions of current
law provide any basis for imposing similar restrictions on the nature of an
SPBF's income or activities?

Perhaps the reason for the special rules in the trust area is a problem
unique to that form of entity-the problem of taxing income to unknown
beneficiaries, such as an unborn child. One author has suggested that, in such
a situation, a withholding tax should be imposed on the entity at the highest
individual tax rate, and that the law, through relatively mechanical rules,
would then determine which potential beneficiary is the proper taxpayer.'67

That "taxpayer" can then take a credit (with the possibility of generating a
refund) in respect of the trust's prior withholding tax payment. In other
words, the trust would be subject to a temporary entity tax with a relief
mechanism to avoid double taxation. The proposal helps to bring the taxation
of trusts and estates closer to the taxation of other pass-through entities.

The nature-of-income limitations for RICS, REITs, REMICs, FASITs,
and publicly traded partnerships may simply be part of the tax law's
condition for permitting such publicly traded entities to obtain pass-through
treatment. In addition, there may be securities law reasons for some of the
limitations. If there were no such limits, the pass-through regime could
become the norm for all businesses-for example, General Motors could
become a RIC. Because there is no consensus regarding why the income of
public firms should be taxed twice, it is not surprising that the exact nature
of these restrictions cannot be explained from first principles. Instead, one
might simply conclude that a limitation may be needed in order to maintain
the integrity of the double tax system as applied to public firms, whether such
a system can be justified or not.

In the S corporation context, the rules of section 1375, which restrict
the ability of S corporations to receive passive income, raise issues that are
essentially transitional in nature. An S corporation with no C corporation
history will not run afoul of this rule.

In conclusion, there is no apparent reason to limit the nature of
income or business activity of an SPBF. Existing restrictions applicable to
other entities seem designed to either protect the double taxation of the
income of public firms, protect transitional concerns when a double-taxed
entity is converted into a single-taxed one, or respond to features peculiar to
that entity. Because these explanations are not applicable to an SPBF, no such
restrictions are included in the proposal.

167. Sherwin Kamin, A Proposal for the Income Taxation of Trusts and Estates,
Their Grantors, and Their Beneficiaries, 13 Am. J. Tax Pol'y 215 (1996).

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The Future Taxation of Private Business Firms

d. Size of Enterprise (Measured by Assets, Sales, Income, or
Some Other Measure).-The tax statute is littered with past Congressional
efforts to provide special treatment for "small businesses." These provisions
are in addition to the many special rules applicable only to subchapter S
corporations. Most of the provisions define small businesses in terms of gross
receipts, but assets and other tests have been employed as well.' 68

In addition to its other eligibility conditions, should an SPBF be
limited by size? From the Treasury's perspective, smaller enterprises
generally present tax issues of only limited significance. Thus, if a more
relaxed set of operating rules eliminating some of the protective features of
subchapter K is to be provided to a subset of firms, it might make sense to
limit the availability of those rules to small businesses.

From the taxpayer's vantage point, small businesses are likely to have
less sophisticated owners and advisors than larger businesses. Therefore,
small businesses would particularly benefit from a simplified tax rule
structure. Although larger businesses would also benefit from simplification,
they might have alternative means not available to smaller businesses of
coping with tax law complexity.

168. See, e.g., IRC §§ 44(b) (business with gross receipts not exceeding S1 million
or one having no more than 30 full-time employees), 55(e)(1) (corporation with average annual
gross receipts for three preceding years not exceeding $5 million (or $7.5 million after 1997)),
447(d) (gross receipts not exceeding $I million or, in certain cases, $25 million), 448(c)
(average annual gross receipts for three preceding years not exceeding $5 million), 474(c)
(same), 6721(d)(2)(A) (same), 263A(b)(2)(B) (average annual gross receipts for three preceding
years not exceeding $10 million), 460(e)(1)(B) (same), 613A(d)(2) (certain gross receipts may
not exceed $5 million), 508(c)(1)(B) (gross receipts normally not more than $5,000),
6033(a)(2)(A)(ii) (same), 6113(b)(2)(A) (gross receipts normally not more than $100,000),
1044(c)(3) (any partnership or corporation licensed by the SBA under § 301(d) of the Small
Business Investment Act of 1958), 1202(d)(1) (gross assets not exceeding S50 million),
1244(c)(3) (shareholder contribution, including paid-in surplus, not exceeding SI million),
243(a)(2) (must be small business investment company operating under the Small Business
Investment Act of 1958), 246A(b)(2) (same), 582(c)(2)(A)(iii) (same), 1242 (same), 1243
(same), 542(c)(8) (same, except that firm must be actively engaged in business of providing
funds to small business concerns), 220(c)(4) (average of 50 or fewer employees during either
of two preceding calendar years), 4980D(d)(2) (average of at least two but not more than 50
employees during preceding calendar year), 6053(c)(4) (10 or fewer employees during
preceding calendar year). Certain other provisions are designed to be limited to small
businesses through a phase-out or other mechanism. See, e.g., IRC §§ 1 l(b) (phase-out of low
brackets for corporations with higher income), 179(b)(2) (phase out of § 179 expensing benefit
where amount of § 179 property placed in service begins to exceed $200,000), 195 (special
rule limited to "start-up expenditures"). Similar rules have been included in recent proposals.
See, e.g., Treasury Integration Report, supra note 28, at 42 (businesses with gross receipts less
than $100,000 not subject to CBIT); Berger, supra note 63, at 165 (distinguishes one-tier from
two-tier entities based on their total revenues, with the dividing line between SO million and
$50 million).

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Florida Tax Review

One problem with a "small business" condition is developing a proper
definition for that term. A dollar-size rule establishes a bright line, but it is
unclear whether a dollar-size limit should apply to assets, receipts, taxable
income, some combination of the foregoing, or something else. "Receipts"
seem to draw too arbitrary a line between capital-intensive and service-based
firms; such a distinction appears unrelated to either the tax advantage
potential of the firm or its need for a simple operating rule structure.
"Taxable income" is probably too inaccurate a proxy for "small business." In
addition, "taxable income" presents the greatest boundary problems, given
how common it is for business income to fluctuate from year to year. 69 An
asset-based test is reasonably stable and somewhat representative of "small
business," yet it entails the potential disadvantage of requiring periodic valua-
tions. 70 It also may arbitrarily distinguish service businesses from oth-
ers. 17 1 In short, any test for small business seems either too arbitrary or
unworkable, and prior efforts to define small business for tax purposes do not
appear helpful.

Another problem with a rule providing preferential treatment to small
businesses is the need to prevent division of a single enterprise into parts
small enough to qualify for that treatment. A number of existing provisions
undertake to accomplish this task, but none seems consistent with a goal of
keeping the system simple. 72 A further concern of any dollar-size rule is
the boundary problem created: how should firms be treated when they flip-
flop onto different sides of the applicable dollar threshold?

A more fundamental concern is that any dollar size rule would
exclude too many firms. Some larger firms, used to the relative simplicity of
subchapter S, would be forced to be taxed under more complex conduit rules
such as subchapter K. Although a larger firm willing to engage in a less

169. See Berger, supra note 63, at 162-63.
170. The proper treatment of debt is also problematic under an asset-based test. See

Berger, supra note 63, at 163. One possible way of reducing the valuation burden is to value
a firnm as of the last noncash contribution to or distribution from the entity, when some value
for the firm was presumably agreed to by the parties, adjusted by the book value of any net
accumulations since that time. But such a rule seems to ignore substantial value, such as the
value of any asset appreciation of the firm since the time of the last noncash contribution or
distribution. In addition, the rule appears to permit the firn to transact a very large economic
deal and still qualify under the applicable dollar test so long as there is a contemporaneous
distribution of the proceeds of the deal to the owners of the firm. That outcome does not seem
consistent with a small business limitation to the SPBF rules.

171. See Timothy D. Wheeler, Partnership Returns, 1994, 16 SOI Bulletin 76, 78
(Fall 1996) (Figure D) (setting forth net income, total receipts, and total assets of partnerships
by industry).

172. See, e.g., IRC §§ 44(d)(2) and (3), 220(c)(4)(D), 474(d)(1), 1202(d)(3); cf. IRC
§ 1561.

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The Future Taxation of Private Business Firms

flexible business arrangement can always obtain a fairly simple tax regime
within the confines of regular subchapter K, it is much easier for taxpayers
to proceed under a prepackaged set of simple tax operating rules than to tailor
their own set to accommodate their individual business needs. If the theory
of the other eligibility conditions of an SPBF is sound, then the size of the
enterprise should not matter. In that regard, the subchapter S rules have never
included a size-of-enterprise limitation.

Some thought was also given to using a dollar size test as the
exclusive eligibility condition for firms entitled to a simpler set of tax
operating rules. The theory is that firms under a certain economic size do not
likely comply with a more rigorous set of rules anyway; the IRS is not likely
to discover whether they do or do not comply; and their small size makes any
resulting tax advantage to the owners a relatively modest concern to the
Treasury. Hence, a highly simplified operating rule structure could be
provided to such firms without much effect on the fisc.

Such an approach would, of course, place considerable pressure on
the definition of "small business" in order to prevent large firms or economic
deals from obtaining the greater tax advantages presumably available under
the simple version of subchapter K. Moreover, even a foolproof definition
would apparently not preclude wealthy and sophisticated taxpayers from
engaging in small economic deals through such small business firms, thereby
obtaining certain tax advantages not otherwise available. Thus, a market of
SPBF tax shelters might develop for the middle and upper income taxpayer.
This concern might be alleviated if the dollar size limitation is low enough
to make purely tax-motivated transactions uneconomic, but of course, an
excessively low threshold would then exclude a number of deserving firms.

Finally, a nagging concern about such an approach is whether it
would ultimately result in any practical benefit to anyone, including
particularly the small economic firms to which the rules would be targeted.
Given the complexity of subchapter K, the lack of significant IRS auditing
of firms subject to those rules, and the general feeling that large parts of
subchapter K are misapplied even by very knowledgeable practitioners, it may
well be that many small firms (as well as some not so small ones) already
utilize a watered-down, intuitive version of subchapter K. This "intuitive K,"
which is surely different things to different people, may well continue to
govern the world of small firms (and some large ones), regardless of what
this article might propose and what the Congress might someday enact. If so,
then a simplified operating rule structure limited to small economic firms may
ultimately be nothing more than an attractive nuisance for which some
sophisticated practitioners may find improper uses.

For all of the foregoing reasons, the proposal does not contain any
test based on the size of the enterprise.

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Florida Tax Review

C. Operating Rule Provisions of the Simplified System

This section sketches out the principal operating rule provisions for
the SPBF system.

1. Explicitly Elective System.-The SPBF operating rules to be
described should be explicitly elective to qualifying taxpayers. Because the
rules are intended to be more administrable than subchapter K generally,
some thought was given to making the rules mandatory for qualifying firms.
In theory, a mandatory rule would eliminate the cost to taxpayers of
determining whether and how to elect the rules and would promote greater
use of the simplified SPBF system.

In reality, however, a mandatory rule may not achieve either
objective. Even without an explicit election, well-advised taxpayers may
nevertheless attempt to determine whether the simplified system is more
favorable to them than the default operating rule system. To avoid the SPBF
rules, a taxpayer need only fail one or more of the eligibility conditions for
an SPBF. In that sense, the SPBF rules are elective one way or the other, and
there seems to be no good reason to force taxpayers to utilize transactional
devices to avoid them. Hence, the proposal provides for an explicit election.

Because some taxpayers, including certain smaller, unsophisticated
firms for which the SPBF rules are specifically designed, may not be aware
of the existence of an election or may fail to comply with whatever procedure
is established for executing it, the proposal provides only for a permissible
election by any SPBF out of the simplified conduit version. A failure to elect
automatically means the SPBF is taxed under the simplified system.'

The subchapter S election under current law is different from the
above. Eligible corporations must affirmatively elect into subchapter S and
all shareholders must consent to the election. 74 Failure to make the S
election means the corporation is taxed as a separate entity under subchapter
C. Presumably, Congress wanted to avoid surprising shareholders regarding
the effect of the conduit election of subchapter S, with the accompanying
counterintuitive obligation on their part to report their share of undistributed
items in the current year."7s Hence, it makes sense to require an affirmative
S election under current law. This article recommends, however, that all
private business firms shall be taxed as conduits. If that recommendation is

173. Both the installment sales and entity classification elections operate in this
fashion. See IRC § 453(d); Regs. § 301.7701-3(b)(1). Despite this feature, this article still
refers to the non-SPBF conduit system as the "default system."

174. See IRC § 1362(a).
175. See James S. Eustice, Subchapter S Corporations and Partnerships: A Search

for the Pass Through Paradigm (Some Preliminary Proposals), 39 Tax L. Rev. 345, 369
(1984).

[VoL 4:3



The Future Taxation of Private Business Firms

adopted, then the norm will be for all owners of private firms to report
currently their share of passthrough items, including undistributed items, and
the consequences of the simplified conduit version should therefore not be a
surprise.

Finally, the elective nature of the SPBF rules emphasizes again the
importance of achieving the proper balance in the substantive outcomes under
the SPBF and default operating rule systems.

2. Passthrough Scheme; Allocations of Tax Items and Debt of the
Firm

a. In General.-The proposal adopts the basic passthrough
structure common to partnerships and S corporations under current law. All
tax items of an SPBF are allocated among the owners of the firm who must
include such items in determining their income tax liabilities. The character
of each item is determined at the firm level, with that character then passed
through and reported by the owners. Owners must take into account their
share of the firm's tax items in their taxable years in which the firm's tax
year ends. Because no limitation is placed on the nature of an SPBF's income
or activities, the tax items to be passed through to the owners should be the
same as those listed in section 702(a) of the Code. If some simplified
passthrough scheme can be devised where fewer categories of items need to
be separately stated and passed through, that simplified rule would apply to
an SPBF as well.

Like an S corporation, an SPBF is generally not permitted to make
special allocations. To accomplish that objective, the SPBF proposals limit
the firm to having only one class of residual ownership interests and
generally require all tax items to be allocated in accordance with the
percentage interests of the residual interest holders. The obvious model is the
"one class of stock" rules in subchapter S.

There is difficulty, however, in defining exactly what a "one class of
stock" rule means in the context of a partnership, LLC, or other unincorporat-
ed venture. Corporate stock generally provides the holder with both a profits
and capital interest in the firm. Moreover, each share of stock in the same
class ordinarily has identical rights with respect to distributions and
liquidation proceeds. Finally, changes in the percentage interest in a given
class of shares arise in connection with a contribution, redemption, or
purchase and sale transaction, all of which may be taxable events and have,
in any event, only prospective effect.'76

176. The permissible allocation of all tax items in a pro rata manner to each day
of the taxable year of an S corporation creates the possibility of a change in interest having
some retroactive effect. See IRC § 1377(a)(1).

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Florida Tax Review

In contrast, it is possible to create partnership or LLC interests which
are "profits only" interests.'77 Ownership interests may not entail any set
formula for distribution and liquidation rights. And changes in percentage
interests may be made by private agreement, ordinarily without tax conse-
quences and potentially with retroactive effect.

The check-the-box regulations will require the Treasury to specify
what an unincorporated venture will need to do to satisfy the "one class of
stock" rule in subchapter S. Under those regulations, an unincorporated firm
may elect to be taxed as a corporation and, if the S eligibility requirements
are satisfied, elect to be taxed as an S corporation. 7 s (An unincorporated
firm might wish to do so, for example, to facilitate a future tax-free
reorganization with a subchapter C corporation.) To date, however, no
guidance has been issued. 79

In the absence of such guidance, the SPBF proposals dictate
restrictions on the terms of the ownership interests of an unincorporated firm
to follow closely the normal consequences in the corporate context. Thus, an
SPBF may have only a single class of residual ownership interests and each
such interest must provide the holder with identical rights with respect to the
income, loss, distributions, and liquidation proceeds of the SPBF. All tax
items (other than income allocated to preferred interest holders, described
shortly) must be allocated in a "straight-up" manner in accordance with the
per-day, percentage share of the owner in the residual class of interests. A
change in interest may occur only upon a contribution, a partial or complete
redemption of an owner's interest, or the purchase and sale of interests by the
owners. Finally, changes in interests may have prospective effect only.

Obviously, these limitations may be too restrictive, and may
unnecessarily undermine the appeal of the SPBF option. For example, they
might seem to preclude the common "money-and-brains" venture where one
or more persons supply all of the capital needs of the firm and other persons
provide services in exchange for a profits only interest. In fact, it may be
possible to accommodate that arrangement and others in the SPBF system (as

177. The term "profits only" interest merely signifies the absence of a capital
interest in the firm. A "profits only" partner may or may not share in the losses of the firm.

178. See Regs. § 301.7701-3(a); Staff of the Joint Comm. on Tax'n, 105th Cong.,
Review of Selected Entity Classification and Partnership Tax Issues, 24 n.48 (Comm. Print
1997).

179. Priv. Ltr. Rul. 96-36-007 (May 30, 1996) involved the transfer of all of the
assets and liabilities of an S corporation to an LLC classified as a corporation for tax purposes
under the prior version of the classification regulations. The Service held that if the transaction
qualifies as an "F' reorganization and ff the LLC meets the requirements of an S corporation,
the transaction would not terminate the transferor's S election and such election would apply
to the surviving entity. The ruling did not specify what the LLC would need to do in order to
meet the requirements of an S corporation.

[Vol 4:3



The Future Taxation of Private Business Firms

they are accommodated in subchapter S) through the use of salary payments,
deferred compensation,"' options,"' restricted stock,"8  straight
debt, 183 and preferred interests (described below). To provide flexibility
beyond these forms would seem to result in the undesirable introduction of
complexity into the SPBF system, such as a required maintenance of capital
accounts.184

b. Preferred Interests.-The proposal, however, does allow
an SPBF to issue limited classes of preferred interests. In effect, this permits
a narrow form of special allocation-a preferred allocation of income to one
or more classes of owners. Permissible preferred interests provide income
preferences only which are fixed and limited to the earnings of the firm, are
not convertible into any other interest of the firm, and do not provide for
redemption or liquidation rights in excess of the issue price of the interest.

A preferred interest generally lies on the border between an equity
interest and debt. For the most part, in an SPBF, the need to distinguish
between equity and debt is not great, particularly when the holder of the
interest is viewed as an owner of the enterprise in any event. The preferred
interest simply allocates part of the income of the firm to one class of owner,
thereby allocating it away from other owners. Ultimately, all the income of
the firm is taken into account by its owners.

Whether a preferred interest of an SPBF is thought of as a form of
debt or equity makes a difference, though. Strictly, holders of equity interests
in a business taxable as a conduit should be allocated income whose character
is determined at the entity level. However, if that rule were applied to
preferred interests, clever planning could convert the preferred interest into
a special item allocation. One preferred class could receive the first $100,000
of capital gain income that happened to arise in that year, another class could
receive the first $100,000 of foreign income arising in a different year, etc.

Therefore, the proposal allows for a preferred interest which will
receive only an allocation of ordinary income, with the firm being entitled to
the equivalent of an ordinary deduction. Thus, the allocation of income

180. See Regs. § 1.1361-1(b)(4).
181. See Regs. § l.1361-1()(4)(iii)(B)(2).
182. See Regs. § 1.1361-1(b)(3).
183. See IRC § 1361(c)(5).
184. It is unclear whether capital accounts might, in theory, already be required for

subchapter S corporations. The regulations provide that the one class of stock requirement is
met so long as the governing provisions provide for identical distribution and liquidation
rights, even though the actual timing of the distributions is not uniform. See Regs. § 1.1361-
1)(2)(i), -l/2)(v), ex. 2. If the timing of distributions varies, some account may be
necessary to keep track of the rights of the shareholders during the interim.

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Florida Tax Review

pursuant to a preferred interest would be analogous to the payment of interest
by the firm to the holder.

The proposal contemplates more than one class of preferred interests
in an SPBF. The different classes are to be distinguished solely on the basis
of their priority: the most senior class would have allocated to it a certain
amount of the firm's income; when that amount has been allocated, the next
senior class would have allocated to it a certain additional amount of the
firm's income; and so forth down to the residual class of interests which
would have the most junior claim to income. The classes are not to be
distinguished based on the nature of the income earned. Thus, there cannot
be one class that receives the first $10,000 of foreign income, another class
that receives the first $10,000 of capital gain income, etc.

Income allocations to preferred interest holders are permissible only
when the firm has earned the money needed to make the allocation, that is,
under circumstances analogous to situations in which a dividend could be
paid by a corporation. Because an SPBF has no equivalent of accumulated
earnings and profits (all income from prior years is effectively "distributed"
for tax purposes through the allocation process), income is allocable only if
the firm has net income for the year in that amount. At the same time, if the
firm has enough income to support the preference, the income is allocable
even though there is no distribution. If no distribution is ever made of
previously allocated amounts, the firm will have ordinary debt forgiveness
income. Such income should cancel out the effect to the residual owners of
the prior income allocation.

Allocations must be made based on the period the preferred interest
is held and the extent of the holder's interest. For example, suppose on
December 1, a taxpayer purchases a preferred interest in the first $12,000 of
a calendar-year firm's annual income and holds that interest until the end of
the calendar year. The taxpayer may not be allocated more than $1,000 of the
firm's income for the year.

Although allowing preferred interests increases the flexibility of
owners of SPBFs, it should not override the general prohibition against
special allocations. Thus, suppose the taxpayer in the above example attempts
to purchase on December 31 a preferred interest in the first $3,650,000 of the
firm's income. The allocation rule described above would allow $10,000 of
the firm's income to be allocated to the taxpayer. However, the interest would
have to be issued for value. The value of an interest worth $3,650,000
annually should be quite high. Unless the preferred interest was issued for its
true value, general tax doctrines relating to sham transactions should be
applicable to prevent the allocation of $10,000 to the taxpayer.

c. Losses.-As described above, losses of an SPBF may only
be allocated to the residual interest owners of the firm. Consistent with

[Vol 4:3



The Future Taxation of Private Business Firns

sections 704(d) and 1366(d), the passthrough of SPBF losses or deductions
is limited to such owner's basis in residual or preferred interests in the firm
as of the end of the year in which the loss is incurred. Any losses passed
through to an owner would reduce his or her outside basis in the same order
as in current subchapter S-first to the owner's basis in residual interests, if
any, and then to the basis of any preferred interests.'8 Any losses disal-
lowed by reason of the basis limitation shall be treated as incurred by the
firm in the succeeding taxable year with respect to the owner involved.'

d. SPBFLiabilities.--One major difference between the rules
of subchapter K and the rules of subchapter S is that partners but not S
corporation shareholders include both recourse and nonrecourse debts of the
entity in their outside bases.'

Inclusion of debt in outside basis provides partners with several
potential tax benefits. Because distributions from both a partnership and an
S corporation are taxable to the extent money distributed exceeds outside
basis, the partnership rule reduces the likelihood of a partner being taxed in
such a transaction.' 8 For a similar reason, contributions of property
encumbered by liabilities in excess of the transferor's basis in the property
are more likely to be taxable transactions in the world of subchapter S than
subchapter K. 89

But the major consequence of including debt in basis is that it
increases the likelihood that the owner can deduct losses incurred by the
entity. This outcome results from the rule for both S corporations and
partnerships which generally limits an owner's deduction of losses to the
amount of his or her outside basis.'90 As just described, such a rule is
included in the SPBF system.

The decision of whether to include entity debt in the basis of owners
of an SPBF is a difficult one. As a theoretical matter, some might argue that
the paradigmatic case justifying inclusion of debt in outside basis is the
general partnership whose partners are jointly and severally liable for all of
the firm's debts. Under those circumstances, it makes sense to provide the
partners with tax basis for their share of the firm's liabilities. Adherents to
this view might point to the absence of a comparable provision in subchapter

185. Cf. IRC §§ 1366(d)(1), 1367(b)(2).
186. Cf. IRC § 1366(d)(2).
187. See IRC § 752.
188. See IRC §§ 731(a)(1), 1368(b).
189. See IRC § 357(c). Partners are generally taxed only if the net amount of

liability relief (after taking into account the partner's share of the resulting partnership liability)
exceeds the partner's basis in the property transferred. See Regs. § 1.752-1 (0; IRC § 731 (a)(1).

190. See IRC §§ 704(d), 1366(d).

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S, perhaps because of the limited liability protection offered the shareholders
of an S corporation. Thus, it could be argued that entity debt should be
included in the outside basis of an owner only in circumstances where the
owner is personally liable for repayment of the debt.

Such a rule would draw a sharp distinction between taxpayers based
on their choice of organizational form-proprietors, co-owners, and general
partners, for example, would obtain basis for their business debts, but owners
of other firms, such as limited partnerships, limited liability companies or
corporations, would not. It might discourage the use of the latter forms of
business organization. It would also be at cross purposes with the current law
entity classification rules which generally disregard limited liability and other
organizational characteristics for income tax purposes.

Moreover, current law allows taxpayers to receive tax basis for
indebtedness even though the taxpayer is protected from personal liability on
the debt because it is nonrecourse.191 That tax principle would seem to
reduce the force of a distinction based on the presence or absence of limited
liability protection for the owners of the firm.

In addition, as a practical matter, many smaller businesses, regardless
of their organizational form, are able to borrow money only if their owners
are held accountable for the borrowing, for example as guarantors. If entity
debt were included in an owner's outside basis only if the owner were liable
for the debt, would an owner guarantee affect basis?"9 If not, owners may
simply be forced to structure their borrowing in certain ways-for example,
borrowing directly and then contributing the proceeds to the firm-rather than
using other, more natural and more easily attainable ways. As is true in
subchapter S, there would be a premium on proper tax planning. Other
complicated rules may also be needed to relieve the absence of rules like
section 752, such as the provisions in subchapter S enabling losses to be
deducted up to debt basis.' 93

191. See Crane v. Commissioner, 331 U.S. 1 (1947).
192. In subchapter S, the answer generally is "no." See, e.g., Estate of Leavitt V.

Commissioner, 90 T.C. 206 (1988), aff'd, 875 F.2d 420 (4th Cir. 1989), cert. denied, 493 U.S.
958 (1989); Harris v. United States, 902 F.2d 439 (5th Cir. 1990). In both subchapter K and
in determining whether the guarantor is "at risk" with respect to the liability, the answer may
be "yes," generally depending upon the nature of the primary obligor's obligation and the
reimbursement rights of the guarantor. See Regs. § 1.752-2(b)(3)(i), (5), and (6); Prop. Regs.
§ 1.465-6(d) (guarantee does not increase at risk amount); Brand v. Commissioner, 81 T.C.
821 (1983) (guarantee does not increase at risk amount because of guarantor's right of
indemnification against the partnership); Peters v. Commissioner, 89 T.C. 423 (1987) (same);
Abramson v. Commissioner, 86 T.C. 360 (1986) (guarantee increased at risk amount because
there was no primary obligor and no right of reimbursement from anyone).

193. See IRC § 1366(d)(1)(B).

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The Future Taxation of Private Business Firms

Finally, the basic case against inclusion of entity debt in outside basis
is not limited to the taxation of an SPBF; the argument applies with equal
force to non-SPBF private business firms. In other words, the argument
would question the presence of section 752 in the default version of conduit
taxation, i.e., subchapter K, and not just in the SPBF system. This follows
from the fact that the SPBF classification line is not based on the limited
liability protection offered to the owners of the firm.

Indeed, for several reasons, a much stronger case could be made to
exclude section 752 from the default conduit version than to exclude it from
the SPBF system. For one thing, inclusion of debt in basis increases the
amount of losses of the firm currently available to owners. It therefore places
greater pressure on the proper allocation of those losses. But unlike the
default version of conduit taxation, which may be vulnerable to potential
misallocations of tax items, the SPBF system mandates a straightforward
allocation scheme designed to preclude manipulative possibilities. In
particular, all losses of an SPBF are allocable only to residual interest holders
in accordance with their percentage interest in that class of ownership. Hence,
the inclusion of debt in basis is much less likely to result in an abusive
outcome in the SPBF system than in the default system.

Second, the allocation of debt of the firm among the owners is
considerably more difficult for the default conduit system than in the SPBF
system. In subchapter K, for example, the regulations under section 752
generally attempt to allocate partnership debt among the partners in
accordance with the manner in which they share the economic risk of loss
relating to the liability.194 Yet to determine that share, the regulations
require one to fantasize a completely improbable scenario--a constructive
liquidation of the partnership under the worst possible circumstances.'
This process is a complicated one and leaves serious doubt whether the
allocation of liabilities authorized by the regulations is appropriate.'9

Further, the basic economic risk of loss analysis does not apply in
determining the allocation of nonrecourse liabilities of a firm, or of any
liabilities of a firm, all of whose owners are provided with limited liability
protection."' These problems are virtually eliminated in an SPBF where all

194. See Regs. § 1.752-2(a).
195. See Regs. § 1.752-2(b)(1).
196. See Berger, supra note 63, at 123 ("At best, the § 752 technique for measuring

a partner's 'economic risk of loss' offers a crude surrogate for quantifying a partner's actual
risk, which is indeterminate; inevitably, the § 752 calculation exaggerates the partner's
exposure.").

197. See id. at 137 ("[A]llocations rooted in nonrecourse debt cannot have economic
reality, or any reality, whatsoever, except in the ingenious, magical and mechanical world of
the § 704(b) regulations.").

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Florida Tax Review

liabilities, recourse and nonrecourse, as well as the losses of the firm may be
allocated straight up to the owners in accordance with their residual
ownership interests.

Finally, the "at risk" (section 465) and passive activity loss (section
469) rules provide another layer of protection against the improper deduction
of losses by taxpayers, and that protection is particularly effective in the
SPBF context. This is because the principal taxpayers exempt from those
rules are nonclosely-held C corporations. 98 But as previously described, a
public C corporation may not be an owner of an SPBF. Thus, in contrast to
the owners of firms taxed under the default conduit system, all owners of an
SPBF would be subject to the at risk and passive activity loss restrictions.

Indeed, the broad applicability of the at risk rules in an SPBF setting
seems to make unnecessary a rule restricting the passthrough of SPBF debt
only to owners personally liable for repayment of the debt. Such a rule in fact
was enacted in 1976'9' but was repealed just two years later as "redundant"
in view of an expansion of the at risk rules." Since that time, the at risk
rules have been expanded even more20' and, as noted, they would provide
virtually full coverage to participants in an SPBF venture. Thus, limited
partners, members of an LLC, and other owners with limited liability
protection are generally not treated as being "at risk" with respect to their
firm's debts, recourse or nonrecourse.2 "2 They therefore may be unable to
deduct their share of losses attributable to those debts even if their outside
bases were sufficient to permit the deduction.2"3

To be sure, certain nonrecourse real estate financing falls outside of
the at risk rules.2 4 Thus, one might argue that those rules provide an
inadequate shield against the claiming of uneconomic passthrough losses.
Whatever the merits of the real estate exception, however, one cannot expect
the issue to disappear in a debate regarding whether to include a firm's

198. See IRC §§ 465(a)(1)(B), 469(a)(2)(B). A C corporation is subject to the at risk
rules if five or fewer individuals own more than 50% of the corporation. See IRC § 542(a)(2).

199. See Tax Reform Act of 1976, Pub. L. No. 94-455, § 213(e), 90 Stat. 1520,
1548 (1976) (amending § 704(d)).

200. See Revenue Act of 1978, Pub. L. No. 95-600, § 201(b)(1), 92 Stat. 2763,
2816 (1978); Staff of the Joint Comm. on Tax'n, 96th Cong., 1st Sess., General Explanation
of the Revenue Act of 1978 130 (Comm. Print 1979).

201. See Tax Reform Act of 1986, Pub. L. No. 99-514, § 503(a), 100 Stat. 2085,
2243 (1986) (repealing blanket exclusion from at risk rules of real property activities).

202. See S. Rep. No. 938, 94th Cong., 2d Sess. 49 n.3 (1976), reprinted in 1976
U.S.C.C.A.N. 3439, 3485; McKee, Nelson & Whitmire, Federal Taxation of Partnerships and
Partners 10-171 (3d ed. 1997).

203. See IRC § 465(a)(1). See Eustice, supra note 175, at 399 (would let at risk
rules rather than outside basis dictate significance of owners' personal liability for entity debt).

204. See IRC § 465(b)(6).

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The Future Taxation of Private Business Finns

nonrecourse financing in an owner's outside basis. Presumably, the same
interests which have successfully exempted certain real estate financing from
the at risk rules would push for inclusion of the same financing in outside
basis. Thus, the basic issue concerns the merit of the real estate exception; it
is unreasonable to assume that the issue will somehow be circumvented by
shifting the controversy to section 752. And for that reason, there is no basis
to decide the section 752 question because of concern about the real estate
exception.

In conclusion, including entity debt in the outside basis of SPBF
owners would help to eliminate tax distinctions based on organizational form
and characteristics and permit businesses to finance their activities as they
wish, without regard to tax considerations and tax planning. Further, the
restrictive allocation rules of an SPBF and the broad applicability of the at
risk and passive activity loss rules to SPBF owners would protect against the
potential misuse of resulting passthrough losses. Finally, as an administrative
matter, the allocation of the debt to SPBF owners could be done in a
straightforward manner based on the owners' shares of the residual interests
of the firm. Although certain of these reasons are inapplicable to the default
version of conduit taxation-and, therefore, additional thought must be given
to whether section 752 principles should be available in that world-these
reasons seem more than adequate to justify inclusion of those principles in
the SPBF system.205

3. Contributions and Distributions

a. Contributions-Present La.-Almost any contribution to
a partnership in exchange for a partnership interest is tax-free. The major
exception is the contribution of services in exchange for an interest in the
capital of the partnership. 'z In general, the IRS treats the receipt for
services of a mere partnership profits interest as being tax-free. 7

In contrast, contributions to an S corporation are governed by the
same rules that apply to all corporations.' Accordingly, a transfer of
property to an S corporation in exchange for its stock is tax-free only if the
transferor, either alone or with a group of transferors, owns at least 80%
control of the corporation following the transfer.20 Furthermore, any stock

205. Inclusion of § 752 principles in the SPBF system, but not the default system,
would have the side benefit of increasing the appeal of the simplified system to taxpayers.

206. See United States v. Frazell, 335 F.2d 487, 489 (5th Cir. 1964). cert. denied,
380 U.S. 961 (1965).

207. Rev. Proc. 93-27, 1993-2 C.B. 343.
208. See IRC § 1371(a)(1).
209. See IRC § 351.

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Florida Tax Review

of an S corporation received in exchange for services is taxable to the
recipient."' Although this rule is different from the partnership rule, it
results from the fact that an S corporation has only one class of stock. Thus,
stock in an S corporation must inevitably carry with it an interest in the
capital of the corporation. As noted, when services are contributed in
exchange for partnership capital, the transaction is taxable.

The tax authorities early on accepted the proposition that a contribu-
tion of property to a partnership in exchange for a partnership interest is not
a taxable event. 21' The 1920 Solicitor's Opinion which first makes this
point quotes United States v. Coulby,21 2 for the proposition that "[u]nlike
a corporation, a partnership has no legal existence aside from the members
who compose it." The Solicitor's Opinion goes on to say:

It thus appears, both from the decision of the Federal court and from
the ruling of this department, that, for income tax purposes, the
common law doctrine of the nature of a partnership must be adhered
to, and that the more modem doctrine, prevailing in some States,
which recognizes a partnership for many purposes as an entity not
greatly differing from the corporation, must be ignored.

A 1932 General Counsel Memorandum emphasizes that this rule is a function
of nonrealization, not nonrecognition, since the statute did not provide any
special rule in this area.2" 3 The General Counsel Memorandum extracts
from this analysis the rule now embodied in section 704(c). That is, if a
contribution of appreciated property to a partnership is not considered a
realization event yet the contributing partner is given economic credit for the
full value of the property, then it follows that the gain inherent at the time of
the contribution must be allocated to such partner." 4

A partner recognizes gain, and a shareholder of an S corporation
recognizes gain or loss, upon a transfer of property to a firm qualifying as an
"investment company. 2 5 The 1997 Act broadened the definition of
investment company to stem the reappearance of "swap funds," i.e., firms

210. See IRC § 351(d)(1).
211. Sol. Op. 42, 3 C.B. 61 (1920).
212. 251 F. 982 (6th Cir. 1918).
213. Gen. Couns. Mer. 10,092, XI-1 C.B. 114 (1932), revoked on another issue,

Gen. Couns. Men. 26,379, 1950-1 C.B. 58.
214. The courts did not accept this position of the Commissioner, and the result

ultimately had to be achieved by statute. See Eaton v. Commissioner, 37 B.T.A. 715 (1938);
see also Helvering v. Walbridge, 70 F.2d 683 (2d Cir. 1934) and Helvering v. Archbald, 70
F.2d 720 (2d Cir. 1934).

215. See IRC §§ 351(e)(1), 721(b).

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The Future Taxation of Private Business Firms

permitting investors to obtain tax-free diversification of their investment
assets.

216

b. Distributions-Present Lav.-In contrast to the roughly
comparable provisions for contributions, the rules dictating the tax conse-
quences of distributions from a partnership or S corporation are much
different. A partnership is never taxed on a distribution to a partner as
such.2 17 In some cases, as discussed subsequently, complicated rules may
cause the partnership distribution to be recharacterized as something else, but
there is no tax absent such recharacterization. In contrast, distributions from
an S corporation are governed by the anti-General Utilities rules of sections
311 and 336, which cause gain inherent in the distributed property, and loss
inherent in property distributed in liquidation, to be recognized by the
corporation (and passed through to the shareholders) as if the property had
been sold.

The taxation of the distributee is also much different. The partnership
rules minimize the amount of gain or loss that must be recognized in a
distribution. In doing so, they rely on a partner's outside basis as the final
determinant of how much basis will be available to the partner following the
distribution and how much gain or loss must be recognized in the transaction.
Indeed, it is generally only where money distributed exceeds outside basis
that gain must be recognized, because the basis of money cannot be reduced
below its face value.18 And it is generally only where a partner's outside
basis would otherwise be lost forever, as in the case of a liquidating
distribution of money less than the distributee's outside basis, that loss may
be recognized. 219 The nonrecognition objective and the policy decision to
rely upon outside basis result in certain complications where outside basis and
the aggregate inside bases of the properties distributed are different from one
another.Y

The S corporation rules are different In an ordinary distribution, a
distributee must recognize gain to the extent the money and value of property
distributed exceed the distributee's stock basis."' A similar rule applies in

216. See Staff of the Joint Comm. on Tax'n, 105th Cong., Ist Sess., General
Explanation of Tax Legislation Enacted in 1997, 183 (Comm. Print 1997).

217. See IRC § 731(b). This discussion assumes that a liquidating distribution is
taxed as a distribution under § 736(b)(1) rather than as a distributive share or guaranteed
payment under § 736(a).

218. See IRC § 731(a)(1). Section 731(c) is an exception to this rule discussed later.
219. See IRC § 731(a)(2)(A). Loss is also recognized to prevent the distributee's

excess outside basis from being allocated to ordinary income items distributed. See IRC
§ 731(a)(2)(B).

220. See IRC § 732.
221. See IRC § 1368(b).

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Florida Tax Review

a liquidating distribution except that the shareholder may recognize loss as
well.m Finally, gain or loss is recognized in a partial liquidation of a
shareholder's interest except that the shareholder's outside basis must be
allocated to the shares redeemed.' Thus, in combination with the tax
treatment of the corporation, all gains and most losses are recognized in a
distribution by an S corporation. The shareholders therefore receive a fresh-
start fair market value basis in any property distributed.224

c. Additional Partnership Rules to Prevent Income Shifting,
Income Character Changes, and Timing Distortions.-As just described, the
partnership tax rules are more liberal than the S corporation rules in permit-
ting property to be transferred into and out of the firm without the recognition
of gain or loss. The generally unimpeded nature of partnership transfers has
necessitated basis preservation and allocation rules as well as a series of
additional rules designed to prevent income shifting, income character
changes, and timing distortions. As a conceptual matter, because property
more frequently changes ownership in the partnership world without the
recognition of gain or loss, there is greater pressure to develop and maintain
links between the property transferred and the original owner to make sure
the eventual recognition of income or loss is of the right amount, to the right
person, of the right character, and at the right time. The following is just a
sample of the provisions that have been developed to achieve those ends:

i. Section 704(c)(1)(A).-We have already seen the
IRS's early recognition of the need for a rule to prevent the shifting of gains
or losses from the contributor of built-in gain or loss property to some other
partner. As an important exception to the rule that all allocations must have
economic effect, section 704(c)(1)(A) requires a special allocation of such
gains or losses back to the contributor.

A common problem occurs under section 704(c)(1)(A) where the
subsequent tax items arising from the partnership's ownership of the
contributed property are less than the amount of built-in gain or loss at the
time of the contribution.' For example, land contributed with built-in gain

222. See IRC §§ 331(a), 302(a).
223. See IRC § 302(a). The term "partial liquidation" refers to a transaction in

which a distribution redeems some, but not all, of the distributee's interest in the firm. It
should not be confused with the use of the term in §§ 302(b)(4) and (e), dealing with
liquidating events occurring at the entity level.

224. See IRC §§ 301(d), 334(a).
225. One commentator states that ceiling-limited situations constitute a "pervasive

obstacle to satisfying the objectives of § 704(c)" and speculates that they arise in over one-half
of all possible cases. See John P. Steines, Jr., Partnership Allocations of Built-in Gain or Loss,
45 Tax L. Rev. 615, 647 (1990).

[Vol 4:3



The Future Taxation of Private Business Firms

of $7,000 might be subsequently sold by the partnership for a $6,000 gain.
Economically, this transaction could be broken into a $7,000 gain to be
allocated to the contributor plus a $1,000 loss to be shared by all of the
partners. The so-called "ceiling rule," however, generally does not permit that
outcome.226 Apparently, the concern of the Treasury has been the extension
of partnership "flexibility" into a world of make-believe, i.e., a world in
which a $7,000 gain and a $1,000 loss are being allocated to the partners
when, in fact, neither tax result actually occurred. This concern is warranted
because the propriety of both the "$7,000 gain" and the "$1,000 loss"
depends upon the accurate valuation of the property initially, a questionable
assumption in certain cases. Thus, the ceiling rule permits a special allocation
of at most $6,000 in this example, the amount of tax gain actually recognized
by the partnership from the sale of the property.

The current regulations offer three ways of dealing with the problem
of ceiling-limited transactions. One possibility is to ignore the problem, which
permits a certain amount of income shifting to occur.m To protect the fisc,
however, and to further complicate matters, taxpayers may not choose to
ignore the problem if they entered into the ceiling-limited transaction "with
a view" towards gaining that tax advantage.' Another possibility is to
make so-called "curative allocations" of tax items unrelated to the contributed
property in order to make up for the shortfall.' Curative allocations are
allocations of tax items only and thus also violate the economic effect test. In
a general effort to conform the cure to the problem, various restrictions are
imposed on the amount, character, and timing of the tax item subject to the
curative allocation" and curative allocations are impermissible in certain
cases where the taxpayer has the wrong subjective purpose." A final
option is to make "remedial allocations," which are similar to curative
allocations except that they are entirely make-believe. '  Rather than
repealing the ceiling rule altogether, the IRS has prescribed remedial
allocations as the one permissible method for creating fictitious allocations
in order to avoid the undesirable effects of the ceiling rule.233

226. See Regs. § 1.704-3(b)(1).
227. See Regs. § 1.704-3(a)(1), -3(b)(1).
228. Regs. § 1.704-3(a)(10), -3(b)(2), ex. (2)(ii).
229. Regs. § 1.704-3(c)(1).
230. See Regs. § 1.704-3(c)(3).
231. See Regs. § 1.704-3(c)(4), ex. (3). For the view that these subjective overrides

should have only a limited reach, see Laura E. Cunningham, Use and Abuse of Section 704(c).
3 Fla. Tax Rev. 93, 115 (1996).

232. See Regs. § 1.704-3(d)(1) (authorizing the creation of remedial items by the
partnership).

233. See Regs. § 1.704-3(d)(5)(i).

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Florida Tax Review

ii. Reverse Section 704(c) Allocations.-The need for
a reverse section 704(c) allocation arises whenever there is some change in
the ownership of a partnership and one or more partnership assets contains
a built-in gain or loss at that time. Thus, if new partner C joins existing
partners A and B at a time when partnership AB has certain assets with built-
in gains, those gains must be specially allocated to A and B and away from
C in order to prevent income shifting among them. Of course, certain of those
gains might already be subject to an existing, "regular" section 704(c) special
allocation if the asset was contributed by A or B with a built-in gain or loss,
so matters can get complicated fairly quickly.2" The regulations deal with
reverse section 704(c) allocations in the same manner as regular section
704(c) allocations. 5 Under the regulations, however, just to make sure
everyone stays alert, partnerships are not required to use the same allocation
method for both regular and reverse section 704(c) adjustments even if such
adjustments relate to the same property at the same time.236

iii. Section 704(c)(1)(B).-Assuming that one can
keep track of all of the required and prohibited special allocations, they
would nevertheless not be wholly effective at preventing the potential income
shifting from built-in gains and losses. One reason is that special allocations
under section 704(c)(1)(A) only apply to tax items of the partnership;
therefore, if property subject to a special allocation somehow escapes the
partnership in a nonrecognition transaction, such as through a distribution to
a partner other than the contributing partner, then the mandated special
allocation is rendered impotent. Section 704(c)(1)(B) generally deals with that
problem by providing that a distribution of built-in gain or loss property
within seven years of its contribution to the partnership triggers gain or loss
to the contributing partner equal to the amount that would have been specially
allocated to such partner had the partnership sold the property. 3"

iv. Section 737.-Another reason a mandated special
allocation might prove to be ineffective is if the partner to whom the built-in
amount is to be allocated ceases to be a partner prior to such allocation.
Special allocations only serve to shift tax items among partners of the

234. Regular special allocations of the gains and other tax items from the property
may also be permitted or prohibited depending upon compliance with the substantial economic
effect test and one or more subjective purpose standards.

235. See Regs. § 1.704-1(b)(4)(i) and -1(b)(5), exs. (14)(i) - (iv), (18)(ii) - (xiii).
236. See Regs. § 1.704-3(a)(6)(i). Nor are partnerships required to use the same

allocation method in coping with a series of reverse § 704(c) adjustments. See id.
237. Query whether the rule should also apply to built-in gains or losses arising not

just from a contribution but also in a reverse § 704(c) situation.

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The Future Taxation of Private Business Firms

partnership; thus, to do the job right, one must monitor potential tax-free
disappearances of partners by means of, for example, a liquidation of the
partnership interest. Indeed, in certain cases, tax advantage may be gained
even if the contributing partner does not completely disappear from the scene,
but is only the recipient of a tax-free distribution. Congress took its first step
down this road by enacting section 737 which generally treats as a gain
recognition event a distribution of property to a partner who contributed built-
in gain property to the partnership within the previous seven years.

v. Section 707(a)(2)(B).-In addition to income-
shifting concerns, the liberal manner in which property can enter and leave
a partnership without the recognition of gain or loss raises the question
whether the contribution and distribution are in reality a taxable sale. Section
707(a)(2)(B) attempts to make this nebulous determination based upon
whether the two transfers "are properly characterized as a sale or exchange
of property." The regulations interpret this unhelpful statutory standard by
creating a two-year rule of thumb as well as a series of additional rules.
There is a rebuttable presumption that transfers occurring within two years
of one another constitute a sale or exchange and that those outside that time
frame are not"23

vi. Section 731(c).-A related concern is addressed
by section 731(c), enacted in late 1994. Recall that cash distributions from a
partnership are generally taxable to the extent the cash exceeds the dis-
tributee's basis in the partnership, but property distributions are generally tax-
free. In a remarkably convoluted rule, section 731(c) treats a portion of
"marketable securities" as cash for purposes of the distribution rule. Thus, a
distribution of marketable securities may result in gain recognition to the
distributee. According to the legislative history, the transaction is the
"economic equivalent of a sale of a partner's share of the partnership's
[other] assets" for an increased share of the partnership's marketable
securities." This characterization of the transaction bears resemblance to
section 751(b), described next.

vii. Sections 724, 735, and 751(b).-Liberal
nonrecognition rules on property transfers breed a greater need for income
character tracing rules to prevent a character shift when the tax consequences
from the property are ultimately recognized. Section 724 traces the character

238. See Regs. § 1.707-3(c)(1), -3(d).
239. H.R. Rep. No. 826, 103d Cong., 2d Sess. 187 (1994), reprinted in 1994

U.S.C.C.AN. 3959.

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Florida Tax Review

of contributed property and section 735 serves the same purpose for
distributed property. In addition, section 751(b) recharacterizes a distribution
as a taxable exchange by the partners if, as a result of the distribution, there
is a change in the partners' share of the ordinary income items of the
partnership. Because its operative impact is to create an exchange among the
partners, section 751(b) also has an important effect on the timing of the
recognition event. In a partnership distribution, the provision can, with great
surprise, result in the taxation of a partner who is not a distributee on gains
inherent in property which is not distributed.24 As noted, one partnership
tax expert has asserted that there is a mere 2-1/2% compliance rate with
section 751(b)241 and another has characterized it as "the Achilles heel of
subchapter K. 242

viii. Subjective Purpose.-Finally, the general "anti-
abuse" regulation in the partnership area overlays all of the foregoing rules
and may operate to reverse the tax consequences of any one of them.243 As
previously noted, the rule may even override the taxpayer's compliance with
some other, more specific, anti-abuse rule, such as the disguised sale
provision in section 707.2'

d. Analysis of Current Law.-As we have seen, the
partnership tax rules are more liberal than the S corporation rules in providing
nonrecognition of gains and losses upon property transfers to and from the
firm and, as a result, a veritable array of highly complex, anti-abuse rules,
some mechanical in application and some based on subjective standards, have
also developed in the partnership area.245 Although certain of the same
concerns in the partnership area are present for taxpayers in a subchapter S
setting, the S rules are remarkably free of the same complications.246 In

240. See, e.g., Regs. § 1.751-1(g), ex. (3).
241. Hearings, supra note 63 (statement of Joel Rabinovitz).
242. See Eustice, supra note 175, at 383.
243. See Regs. § 1.701-2(b).
244. See supra note 70.
245. For criticism of these anti-abuse protections, see Mark P. Gergen, Reforming

Subchapter K: Contributions and Distributions, 47 Tax L. Rev. 173, 181-98 (1991). See also
Terence Floyd Cuff, The Section 704(c)(1)(B) Proposed Regulations, 73 Taxes 283, 284
(1995) ("The intricate web of anti-abuse rules [affecting contributions and distributions of
partnership property] challenge the most talented partnership tax practitioner .... A
partnership may undertake a seemingly innocent transaction and discover itself tangled in a
web of anti-abuse provisions. These provisions complicate even routine partnership
transactions.").

246. Subchapter S is not, however, completely free of such complications. For
example, S corporations are subject to the collapsible corporation rules, which are similar in

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The Future Taxation of Private Business Finns

part, this phenomenon is attributable to the more restrictive nature of
subchapter S; for example, a section 704(c)(1)(A)-type solution cannot easily
be prescribed where special allocations are not permitted. In part, it may be
a consequence of a policy judgment to maintain a modicum of simplicity for
the S rules. But in important part, it results from the fact that fewer transfers
to and from an S corporation are tax-free.

Moreover, despite this complicated web of rules, partnership
distributions still provide ample opportunity for manipulation by taxpayers.
Manipulation may result from a misallocation or mistiming of income or
other partnership tax items as a result of the distribution, or a conversion of
ordinary income into capital gains.247 To illustrate one conversion possibili-
ty, consider the following simplified example:"48

Example 1. A and B form AB, an equal partnership. A contributes
unimproved land worth $10,000 with a basis of $10,000, and $20,000
cash. B contributes a depreciable asset worth $20,000 and with a
basis of $20,000, and $10,000 cash. The depreciable asset increases
in value to $30,000. AB then liquidates, with A receiving the
depreciable asset and $5,000, and B receiving the land and $25,000.

In the liquidation, neither the partnership nor either of the partners
recognizes any gain or loss. A preserves his or her $30,000 outside basis by
getting $5,000 cash and taking the depreciable asset with a $25,000 basis. B
does likewise by getting $25,000 cash and taking the land with a $5,000
basis. Although the total amount of potential gain in the partnership before
the liquidation ($10,000) is still preserved in the partners' hands afterwards
($5,000 of lurking gain for each partner) the ability to shift basis around from
one asset to another provides potential tax advantages. In effect, the value of
the dollars of basis available to the parties has been increased as a result of
the liquidation, since the basis of the depreciable asset will be used to reduce
ordinary income currently through depreciation deductions while the basis of
the land, which won't be used until the land is sold, may ultimately affect
only the amount of a capital gain recognized in the future.249 In theory, this

objective and complexity to § 751. In addition, to the extent the partnership anti-abuse rule is
simply articulating a common-law "substance over form" standard generally applicable to all
of tax law, the subchapter S provisions are of course subject to that standard.

247. For some examples, see Andrews, supra note 67; ALI 1984 Subchapter K
Proposals, supra note 60, at 195-200; 1997 JCT Partnership Tax Study, supra note 67, at 27-
38; Regs. § 1.701-2(d), exs. (8)-(11).

248. This example disregards the possible application of the general anti-abuse rule
in the partnership area.

249. If the depreciable asset is a § 1231 asset, then increasing its basis may also
provide the taxpayer with an ordinary loss upon sale of the asset. See IRC § 1231(a)(2).

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Florida Tax Review

rule is symmetric; if the land and not the depreciable asset had increased in
value, basis would have been shifted to the land (and away from the
depreciable asset) on liquidation. However, if that had been the case, the
partnership need not have liquidated.

The manipulation possibilities illustrated by example 1 are even
greater as a result of the 1997 tax act. This is because the partnership tax law,
in trying to preserve character due to the nonrecognition consequences of
most partnership distributions, merely segregates certain ordinary income
assets from other assets; it unjustifiably treats all of those other assets
alike." As shown by example 1, this procedure is obviously incorrect to
the extent it lumps depreciable and nondepreciable property together. But it
is even more incorrect under post-1997 Act law because of the additional new
categories of assets created by that Act. Depending upon the tax bracket of
the taxpayer, the nature of the asset involved, and its holding period, gains
on the sale of assets may be taxed at a series of possible tax rates ranging
from 8% to ordinary income rates.5" In addition, the taxation of gains from
real estate will vary, depending upon whether the gain is attributable to the
recapture element of depreciation, the nonrecapture element, or appreciation
in value. And the tax treatment of losses from assets and the use of assets
will continue to be different. In short, current law's treatment of all assets
other than ordinary income assets as essentially fungible items for tax
purposes is now dramatically incorrect, thanks to the changes of the 1997
Act.

To illustrate another potentially erroneous outcome involving the
mistiming and possible exemption of income under the partnership rules,
consider the following example:252

Example 2. D, E, and F form a partnership to start a computer
software business. D and E agree to bankroll the know-how of
partner F. F initially takes a profits only interest in the firm. If the
partnership were liquidated the day after formation, D and E would
split all the money and F would get nothing.

250. See, e.g., IRC § 732(c)(1).
251. See IRC § 1(h), as amended by the 1997 Act. In addition to the difference in

tax rates, the amount of gain subject to tax may also vary, depending upon the asset. See, e.g.,
IRC § 1202(a) (50% exclusion from gain on sale of certain qualified small business stock) and
IRC § 121, as amended by the 1997 Act ($250,000/$500,000 exemption from sale of principal
residence).

252. Cf. Mark P. Gergen, Reforming Subchapter K: Compensating Service Partners,
48 Tax L. Rev. 69, 99-100 (1992). Again, this example disregards the potential application of
the general partnership anti-abuse rule.

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The Future Taxation of Private Business Finns

During the early years, F is compensated through a modest
guaranteed payment, with D and E splitting all losses of the venture.
Business begins to look promising for the product being produced by
the firm. At that point, the partners have a falling out and decide to
split up. The partners book up their capital accounts to reflect the
current value of the firm's product and the firm then liquidates F's
interest, which is now worth $500,000. The partnership purchases and
distributes to F a $500,000 collectible desired by F, which F con-
tinues to hold after the liquidation. Alternatively, the firm purchases
and distributes residential property desired by F worth $500,000
which F lives in for a couple of years and then sells for cash.

Do any of these events, other than the income from the guaranteed
payment, generate any tax consequences to F? True, if F is untaxed, F may
end up with a zero basis in the collectible or the residential property
following the distribution, but F may be willing to hold onto them for some
time, maybe until F's death. 3 And F may sell the residence after living in
it for a minimum period of time and avoid paying any tax whatsoever on
most or all of the gain from the sale.' "

In summary, the enormous complexity of the partnership contribution
and distribution rules and their continued ineffectiveness, which might
foreshadow further change in the rules and even more complication, provide
powerful support for more restrictive rules, such as those in subchapter S, for
the SPBF system. The following sections consider some possible counter-
arguments:

i. Entity Versus Aggregate Theory of the Firm.-It
might be argued that the S corporation rules are consistent with an entity
theory of the firm whereas the partnership rules favor the aggregate or
conduit theory. Because the SPBF system involves a simplified version of
conduit taxation, the partnership and not the S corporation rules should
therefore be the appropriate starting model.

In fact, however, neither the S corporation nor the partnership rules
are supported by either an aggregate or an entity theory of the firm. An entity
theory would suggest that property transfers between the owners and the firm
are generally taxable ones with perhaps some relaxation of that result where
the firm is a mere alter ego of the owner so that the transfer effects a mere
change in form in the owner's investment. 5 But certainly the "alter ego"

253. See IRC § 732(b).
254. See IRC § 121(a).
255. This is the common explanation for § 351. See Portland Oil Co. v.

Commissioner, 109 F.2d 479, 488 (1st Cir. 1940), cert. denied, 310 U.S. 650 (1940).

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Florida Tax Review

exception would not support the general rules in the partnership area, which
permit virtually any transfer of property between a partnership and partner to
be tax-free. Nor would an alter ego or mere change in form exception support
the S corporation rule on contributions. Although one might quibble with
whether 80% is the appropriate standard for measuring a mere change in
form, the S rule permits a tax-free result even though an unrelated group of
persons is necessary to achieve the 80% controlling interest in the corpora-
tion. Certainly, any one person in that group may not have effected a mere
change in form in that person's investment, yet that person gets tax-free
treatment under current law.756 In addition, the S corporation rule taxes
property leaving the corporation even though the recipient is an alter ego of
the corporation, such as a sole shareholder.

An aggregate theory of the firm would suggest that transfers between
an owner and the firm constitute in substance transfers among the owners.
Thus, if a contributor of property is the sole owner, or nearly so, of the firm,
one might excuse the existence of a taxable event because the contributor is
merely transferring the property to himself or herself. Even that nontaxable
outcome is not without some doubt, however, because an important rationale
under current law for not taxing unrealized gains or imputed income is the
absence of a market transaction to measure accurately those gains and
income. If there is at least a semblance of a market transaction, which would
be the case in any contribution or distribution other than, perhaps, one
occurring in a setting involving a sole owner, then the policy against taxing
the transaction is not nearly as compelling. In any event, under an aggregate
theory, one would certainly not extend tax-free treatment to the lengths
provided by either the partnership or S corporation rules. 7 Under the
aggregate theory, a group of investors who join together to pool their
respective capital have made a substantial change in their property rights as
a result of the pooling and, under normal income tax principles, ought to be
taxed.28

As we have seen, the historical explanation for the partnership rule
was based on the common law understanding of a partnership, unlike a
corporation, having no legal existence aside from its partners. But as just
noted, pure aggregate principles do not support a completely tax-free result
in virtually all transfers between the firm and its owners. Moreover, state law

256. See Boris I. Bittker & James S. Eustice, Federal Income Taxation of
Corporations and Shareholders 3.01, at 3-6 (6th ed. 1994); Ronald H. Jensen, Of Form and
Substance: Tax-Free Incorporations and Other Transactions under Section 351, 11 Va. Tax
Rev. 349, 377 (1991).

257. One would also not tax all distributions from S corporations.
258. This is the theory of the recent expansion of the investment company rules. See

supra note 216 and accompanying text.

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The Future Taxation of Private Business Firms

views have continued to evolve away from an aggregate interpretation of the
partnership. 9 Finally, as discussed in part II of this article, tax policy
considerations rather than "aggregate" or "entity" characterizations of a firm
for state law purposes should dictate how the transaction should be taxed.

ii. Tax Policy Considerations.-From a tax policy
perspective, common justifications for a nonrecognition result like the
partnership treatment of contributions and distributions are liquidity and
valuation concerns and the potential lock-in effect of an income recognition
rule.' ° The absence of a liquid means to pay any tax resulting from a
transfer to or from a business is a superficially appealing argument in favor
of nonrecognition. The reality, however, is that there is no general liquidity
exception to the recognition of income, and there are many instances where
the tax system taxes illiquid gains. If the lack of liquidity is considered an
overriding concern, the proper course of action would be to require the
immediate recognition of gains but to permit the payment of tax to be
deferred with interest.26'

Valuation concerns are a little more worrisome. It is true that, except
perhaps where property is transferred between an owner and a wholly-owned
firm, valuation of any property transferred is very likely to have occurred.
Moreover, in those unusual cases where valuation has not, in fact occurred,
the income and character tracing rules such as section 704(c)(1)(A) all carry
with them the requirement of immediate valuation.m Hence, one could
hardly justify a nonrecognition rule based on valuation difficulties if one

259. Under both the UPA and the RUPA, a partner has no interest in specific
partnership property, with the partner's interest in the partnership being classified as
personalty, regardless of the nature of the underlying assets. Unif. Partnership Act § 26, 6
U.L.A. 730 (1995); Unif. Partnership Act § 502 (amended 1994), 6 U.L.A. 67 (1995). Thus,
a partner who transfers real property to a partnership in exchange for an interest in the
partnership has exchanged realty for personalty, which is not even a nonrecognition event
under § 1031. See Regs. § 1.1031(a)-1(b).

260. See Karen C. Burke, Disguised Sales Between Partners and Partnerships:
Section 707 and the Forthcoming Regulations, 63 Ind. LJ. 489, 524-26 (1988); David R.
Keyser, A Theory of Nonrecognition Under an Income Tax: The Case of Partnership
Formation, 5 Am. J. Tax Pol. 269, 288-94 (1986); Philip F. Postlewaite et al., A Critique of
the ALI's Federal Income Tax Project-Subchapter K. Proposals on the Taxation of Partners,
75 Geo. LJ. 423, 471-73 (1986); cf. Maijorie E. Korahauser, Section 1031: Ve Don't Need
Another Hero, 60 S. Cal. L. Rev. 397, 407-11 (1987).

261. Cf. IRC § 453A(c).
262. The capital account rules in the partnership area also require knowledge of the

value of property contributed to a partnership. See Regs. § 1.704-1(b)(2)(iv)(b)(2) and (5).
Similarly, the partnership basis allocation rules enacted in 1997 require valuations. See IRC
§ 732(c).

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Florida Tax Review

intends to comply with all of the additional rules accompanying an initial
nonrecognition result.

Nevertheless, there will be certain instances where the parties have
agreed to valuations only in gross terms and not on a property-by-property
basis. In those cases, a rule requiring the recognition of gains and losses will
cause some difficulty and will inevitably lead to the shaving of income
amounts in the taxpayer's favor. A nonrecognition rule relying solely on basis
amounts avoids these problems. Although valuation concerns are not
significant enough to justify a nonrecognition rule in this instance, they
cannot be dismissed out of hand.

Lock-in-the potential deterrent effect a recognition rule would have
on the movement of capital into and out of businesses-might initially seem
to be a false worry. After all, the cause of the lock-in is the earlier failure to
tax gains as they economically accrued. Thus, one could argue that a
nonrecognition rule improperly channels capital only in certain directions
favored by the rule-for example, the rule encourages the transfer of property
to and from a firm instead of the sale of such property to a third party-and
extends and increases the lock-in effect for the future. By contrast, a
recognition rule terminates the lock-in effect; because it is the realization
principle that creates the distortion in the first place, the best solution to
minimize distortion is to require the realization and recognition of gains at the
earliest feasible moment.263 A transfer of property to or from a business is
a transaction, and often a market transaction, and therefore qualifies as a
feasible opportunity to trigger tax consequences. Any concern about the
overtaxation of capital generally should be dealt with on a more global scale,
such as through the adoption of a consumption tax, rather than in an ad hoc
manner through the proliferation of selective nonrecognition rules.

But perhaps that argument is too facile. Given the existence of the
realization principle, one might well worry that a general recognition rule
would unduly deter transfers of capital to or from businesses. The failure to
tax unrealized gains inherent in property retained by the taxpayer, and not
transferred, could operate as a powerful disincentive against making the
transfer.

The potential importance of the lock-in effect requires judgment
regarding the sensitivity or elasticity of the transfer to the resulting tax
consequences. To make that judgment, it is necessary to consider the nontax
reasons for the transfer. For a transfer of capital to a firm, there would seem
to be at least two reasons: the benefits offered by state law features of the

263. See Keyser, supra note 260, at 285; Daniel N. Shaviro, An Efficiency Analysis
of Realization and Recognition Rules Under the Federal Income Tax, 48 Tax L. Rev. 1, 28
(1992).

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The Future Taxation of Private Business Firns

firm (limited liability, for example)' and the economic benefits of pooling
the property with the capital and services of other investors. In theory, the
greater the nontax benefits obtained, the higher the permissible tax cost of the
transaction without creating an undesirable disincentive to the movement of
capital."

At one time, the nontax benefits obtained from a transfer to an S
corporation might have been considered greater than those from a transfer to
a partnership. Both transfers offered the pooling advantage,' but the S
contribution transfer also achieved the important benefits of incorporation.
Hence, the partnership area perhaps needed a somewhat more liberal non-
recognition rule to be sufficiently responsive to lock-in concerns. In contrast,
because of its greater nontax benefits, contributions to an S corporation could
face a higher tax barrier. This is not to suggest that this difference between
S corporations and partnerships was the basis for the development of their
two different rules, but it is a possible way to rationalize their existence. 67

With the blurring of state law characteristics among the various
business forms, however, the advantages of incorporation may no longer be
significant. Put another way, transfers to a partnership, an LLC, or another,
not yet authorized, unincorporated business form may gradually provide the
same nontax benefits as transfers to an S corporation. This transformation at
the state level, combined with the failure to distinguish private firms for tax
purposes based on their organizational characteristics, suggests that the same
tax rule should apply to property contributions to private business firms,
whether they are taxed under the SPBF system or the default version of
conduit taxation. Moreover, if the S corporation rule has been adequately
responsive to lock-in concerns, it may be an acceptable rule for the SPBF
system. At minimum, concerns about lock-in do not provide any compelling
case for adoption of the more liberal partnership contribution rule.

264. Cf. Note, Losing Control: Toward a New Understanding of the Taxation of
Post-Incorporation Stock Sales, 108 Harv. L. Rev. 1661, 1662 n.7 (1995). By transferring
capital to a firm providing limited liability protection, the transferor potentially protects
untransferred assets from tort and other liabilities arising from the firm's business operations.

265. See Shaviro, supra note 263, at 32-34.
266. We ignore transfers to wholly-owned S corporations because they are tax-free

under current § 351. Thus, the only case where the restrictive nature of the S corporation rule
(in contrast to the partnership rule) on property contributions might come into play is in cases
where there is more than one shareholder.

267. One commentator has suggested that the 80o control requirement in § 351 was
inserted solely to prevent corporations with marketable securities from using their stock to buy
property, thus shielding their vendors from immediate tax (and possibly transforming ordinary
income into capital gain). Because partnership interests are generally not marketable, and
certainly were not when the partnership rule was established, the more liberal nonrecognition
rule was appropriate for transfers to partnerships. See Jensen, supra note 256, at 397.

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Florida Tax Review

A similar analysis applies to distributions. The principal nontax
benefit of a distribution would seem to be the withdrawal of money or
property from the common pool and the resulting ability of the distributee to
make investment or consumption decisions directly. Both partnership and S
corporation distributions provide this same benefit. On the other hand, at least
traditionally, there has been a difference between the nontax consequences of
a liquidating distribution by an S corporation and a partnership: only the
former has entailed the nontax disadvantage of loss of limited liability and
other benefits of state law incorporation.268

Despite this nontax difference, as we have seen, the tax cost of a
distribution by an S corporation is higher than that of a distribution by a
partnership. Thus, from a lock-in standpoint, the partnership and S corpora-
tion tax rules would seem to be exactly the opposite of what they should be.
The S rule, mindful of the somewhat smaller nontax benefits of an S
distribution, should impose a smaller tax burden than the partnership rule to
avoid an undesirable trapping of cash and property within the firm. The fact
that the S rule does not do so of course does not justify it as the correct rule
for the SPBF system. But it does suggest that lock-in concerns may not be
that significant in fashioning the proper rule in this area. And it also offers
no compelling justification for adoption of the partnership distribution rule.

A final observation: although the S distribution rules are more
restrictive than the partnership rules, the difference between the two should
not be overstated. For pro rata cash distributions, the rules are essentially
identical.269 Moreover, if section 751(b) were scrupulously followed by
taxpayers-admittedly a highly questionable assumption-many non-pro rata
property or cash distributions by a partnership may well be caught within its
reaches, thereby triggering potential tax consequences to nondistributees as
well as distributees relating to gains and losses inherent in undistributed as
well as distributed property. In other words, the partnership tax consequences
might be more onerous than the S corporation consequences in many of those
transactions. When one further adds the recent bells and whistles of
provisions such as sections 731(c), 704(c)(1)(B) and 737, it is evident that
many partnership distributions are not nonrecognition events. This observation
bolsters the notion that the choice between the two sets of rules should not
make a significant difference from the standpoint of preventing lock-in.

e. Summary and Proposals.-Income recognition rules for
contributions and distributions are strongly supported by simplification

268. "Liquidating" distributions refer to distributions which completely liquidate the
distributee's interest in the firm, whether or not the firm itself liquidates in the process.

269. See IRC §§ 731(a)(1), 1368(b).

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The Future Taxation of Private Business Firms

objectives, a principal concern of the SPBF system. Furthermore, such rules
are less vulnerable to taxpayer manipulation than nonrecognition rules such
as the partnership rules. In contrast, widespread nonrecognition rules are not
supported by either aggregate or entity principles and entail the highest
transaction costs. Tax policy considerations also do not dictate strongly in
their favor. Therefore, the SPBF system should adopt the following
contribution and distribution rules:

i. Contributions.--Contributions to an SPBF should
follow the S corporation rules with two modifications. First, the 80% control
standard should be significantly reduced. Whatever its historical explanation,
the standard is too high if the purpose of the rule is to distinguish between
real economic exchanges and mere changes in form of ownership of the
property contributed. Lowering the 80% standard will also help to mitigate
concerns about valuation difficulties and lock-in.

At the same time, the "control group" rule in section 351 should not
be adopted for the SPBF system. As previously discussed, the control group
rule permits transferors who clearly are achieving a substantial change in their
property interests in joining a firm to obtain a nonrecognition result, so long
as they join together with others who have a controlling interest in the firm.
This result is not justified by either entity or aggregate principles. Not
including the control group rule also eliminates the need to define what the
group is and avoids the potential surprise to members of the group when one
of them is subsequently disqualified."

Dropping the control group rule may also be a necessary step, as a
practical matter, if one is serious about requiring the recognition of gains and
losses on contributions to an SPBF constituting a real economic change.
Consider a minority owner whose contribution of property to an SPBF would
ordinarily be taxable due to an insufficient ownership interest in the firm. If
there were a control group rule, that taxable result could easily be avoided by
having the other owners accommodate the minority owner and make contem-
poraneous contributions of cash to the firm. Under the proposed rule for
SPBF distributions (described next) as well as the current law applicable to
partnerships and S corporations, pro rata cash distributions from an SPBF are
tax-free to the extent of the distributee's outside basis. Thus, existing owners
with enough outside basis might simply receive tax-free cash distributions and
then recontribute the proceeds to accommodate the minority owner. This

270. Cf. James v. Commissioner, 53 T.C. 63 (1969) (disqualification of one
transferor caused other transferors to be taxed).

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Florida Tax Review

maneuver seems to be possible under existing subchapter S and would also
exist in the SPBF system if the control group rule were retained.27'

ii. No Section 704(c)(1)(A) Rule.-For several
reasons, no section 704(c)(1)(A) rule is proposed for the SPBF system. First,
the rule is needed only where a property contribution to a firm is a nonrecog-
nition event, something that will occur less frequently in the SPBF system
than under current partnership tax law. Second, from the Treasury's
perspective, the principal purpose of the rule is to prevent the temporary
misallocation of tax liabilities among the owners. Eventually, the proper
amounts of gain or loss will be allocated to the proper parties. But the SPBF
ownership restrictions are designed to limit the advantage of temporary shifts
of that nature. Thus, the fisc should be adequately protected even though
section 704(c)(1)(A) is not mandated in the taxation of SPBFs.

Third, inclusion of such a rule would introduce administrative
complexities inconsistent with the goals of the SPBF system. It would require
property valuations on a property-by-property basis in exactly the types of
situations---contributions by transferors who own a significant percentage of
the firm-where precise valuations may not have been made. It would also
be particularly difficult to implement in a tax regime which does not
generally permit special allocations. Moreover, to be wholly effective, any
such rule would also need to overcome the ceiling rule problem and to apply
to reverse section 704(c) situations, both of which would introduce even more
complication. Finally, although the issue arises under current subchapter S,
we take some comfort in the fact that the Treasury has managed to survive
without importing section 704(c)(1)(A) principles into that area.

Some thought was given to returning to pre-1984 law for SPBFs and
to allowing the section 704(c)(1)(A) adjustment to be an option for the
taxpayers. The reason is that the adjustment may be a desirable one for
owners who fail to take into account in their economic dealing the difference
in the tax quality of their respective contributions.272 Thus, for such owners,
a section 704(c)(1)(A) election could relieve a hardship. But elections are
inconsistent with a goal of keeping the system simple. What may be relief for
some may turn out to be an attractive nuisance for many others. In addition,
it was unclear how common the hardship situation actually arises. At least for

271. It may be appropriate to fashion a tax-free exception for certain contributions
to firms for which capital is not a material income-producing factor. This rule would allow,
for example, a service partner who combines his or her firm with an existing service
partnership to avoid being taxed on the contribution of goodwill even though the transferor
does not end up with a sufficient ownership interest in the combined firm to qualify for tax-
free treatment under the general rule.

272. See Berger, supra note 63, at 143-46.

[Vol 4:-3



The Future Taxation of Private Business Firms

regular section 704(c)(1)(A) cases, the issue only comes up when there is a
noncash contribution to a firm, which necessarily requires the parties to make
some determination of the value of the property contributed. Because value
determinations are much more difficult than basis determinations, if the
parties can satisfactorily reach agreement regarding value, it may be
reasonable to expect that they will take into account basis information in their
economic deal as well. This might be particularly true under the proposed
SPBF rule for contributions, which permits a nonrecognition result only
where the contributor has some significant interest in the firm following the
contribution.

iii. Distributions.-Deciding on distribution rules for
the SPBF system that properly balance all of the competing considerations
has been difficult. The foregoing discussion supports SPBF rules more
restrictive than the partnership rules, but it does not indicate how restrictive
they should be.

This article proposes that distributions by an SPBF generally follow
the subchapter S rules but again with certain modifications. First, like current
partnership law and unlike current subchapter S, the taxation of distributees
should be determined by just two categories of distributions, liquidating and
nonliquidating. No special rule shall be provided for partial liquidations.m

In a nonliquidating distribution, a distributee shall recognize gain only to the
extent the amount of the distribution exceeds the distributee's outside basis.
No loss shall be recognized. In a liquidating distribution, a distributee shall
recognize gain or loss in the same manner as a sale or exchange of the
ownership interest. As under current law, in determining the tax consequences
of the distribution to the distributee, the distributee's outside basis should first
be adjusted for any gain or loss recognized by the SPBF in the distribution
and passed through to the distributee. ' 4 In general, distributees shall obtain
fresh start fair market value bases in any property distributed.

Failure to include a partial liquidation rule might seem to create a tax
disparity between such a transaction and a sale by the owner of a portion of
his or her ownership interests to a third party. In the former transaction, there
would not be any required allocation of basis in computing gain whereas in
the latter, there would be. But the two transactions may not be exactly alike
because only the distribution results in a withdrawal of funds from the firm.
In addition, the rules differentiating ordinary distributions from partial
liquidations under current law are generally designed to prevent the former

273. Compare IRC § 302(a). Again, the term "partial liquidation" is used here to
refer to a distribution which effects a partial redemption of the distributee's interest. See supra
note 223.

274. See IRC § 1368(d).

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Florida Tax Review

from being disguised as the latter.27 5 In contrast, in the SPBF system as in
existing subchapter S, tax advantage would be gained from the opposite
strategy, which the existing rules are ineffective at stopping.276 Thus, as a
practical matter, preservation of a partial liquidation rule may serve little
purpose.

2 77

The other modification to the S distribution rules involves a
nonrecognition exception in the SPBF system for distributions constituting a
mere change in form of ownership of the property distributed. This exception
turns on the percentage ownership of the distributee in the SPBF immediately
prior to the distribution, and the percentage may or may not be the same as
for the nonrecognition rule in the case of SPBF contributions. 278 Where the
exception applies, the SPBF does not recognize any gain or loss. The
distributee also does not recognize any loss but must recognize gain to the
extent money plus the basis of any property distributed exceeds the
distributee's basis in the SPBF prior to the distribution. This rule is necessary
to prevent the distributee from obtaining basis without the recognition of a
commensurate amount of income. The distributee inherits the SPBF's basis
in any property distributed, and the distributee's outside basis must be
reduced by the money and the basis of any property distributed.

Example 3. Immediately prior to a nonliquidating distribution, A
owns 90% of the residual interests of an SPBF with an outside basis
of $100. Assume the percentage interest is high enough to qualify for
the nonrecognition exception. In the distribution, A receives property
worth $150 and with a basis to the SPBF of $30. Under the excep-
tion, neither the SPBF nor A recognizes any gain or loss in the
transaction. A takes a $30 basis in the property distributed and
reduces outside basis to $70.

Example 4. Same facts as in example 3 except that the SPBF had a
$130 basis in the property distributed to A. Under the nonrecognition
exception, the SPBF still does not recognize any gain or loss. A,
however, must recognize $30 of gain, the excess of the SPBF's basis

275. See IRC § 302.
276. For example, the distributee might retain an option to acquire the necessary

percentage of ownership interests to prevent a distribution from satisfying the numerical
standard for a disproportionate redemption. Cf. IRC §§ 302(b)(2) and (c)(1), 318(a)(4).

277. Professor Eustice has recommended elimination of the partial liquidation rule
for S corporations. See Eustice, supra note 175, at 406.

278. Different percentages might be justified if, for example, it were considered
more problematic to discourage property contributions to an SPBF than distributions from such
firms.

[VoL 4:3



The Future Taxation of Private Business Firms

in the property distributed ($130) over A's pre-distribution outside
basis ($100). A takes a $130 basis in the property distributed and A's
outside basis is reduced to zero.

An SPBF may elect to have the foregoing exception not apply. An
election is needed because there is one case in which the exception would
produce an unfavorable result for taxpayers. In a liquidating distribution
where the distributee's basis in the SPBF is greater than the money and basis
of property distributed, the exception causes the distributee to lose basis. This
case is illustrated by the following:

Example 5. Same facts as in example 3 except that the distribution
liquidates A's interest in the firm. Also, assume that A's outside basis
in the SPBF just prior to the distribution is $150. Under the nonrec-
ognition exception, no gain or loss is recognized to either A or the
firm and A inherits the firm's basis of $30 in the property distributed.
$120 of A's pre-distribution outside basis has disappeared.

Some thought was given to permitting A to receive a $120 capital
loss in this situation. This would be the mirror image of the rule where the
distributee's pre-distribution outside basis is less than the money plus the
basis of any property distributed. As noted, in that case, the distributee is
required to recognize gain equal to the excess.

Recognition of a capital loss to A might, however, create certain tax
avoidance opportunities. Step back a moment and assume that B previously
owned the property distributed in example 5, with value of $150 and basis
of $30, and was prepared to sell it to A for $150. Assume the property
qualified as a capital asset to B so that a straight sale of the asset would have
resulted in $120 of capital gain to B and a $150 cost basis in the asset to A.
Instead, B contributes the asset tax-free to an SPBF in exchange for 90% of
the residual interests, and then sells the 90% interest to A for $150. On the
sale, B recognizes the same $120 capital gain. If the subsequent liquidating
distribution of the property to A allowed A to claim a capital loss, then A
would receive a $120 capital loss and a basis in the asset of $30. In contrast
to the results of the straight sale, A has basically deducted immediately $120
of the investment. True, the deduction is only a capital loss but if A has
capital gains which need sheltering, this might be an attractive deal.

Consideration was also given to providing A with an exchanged basis
in the asset distributed rather than a transferred basis whenever the exception
applies. For example, in example 5, A would not recognize any gain or loss
and would simply receive a $150 basis in the property distributed.. Current

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Florida Tax Review

partnership tax law generally follows this approach279 but it raises many
difficult questions. For instance, should there be any tax consequences to the
SPBF, either in terms of income recognition or reduction in basis of other
assets, to reflect the increase in the asset's basis from $30 to $150?80 If the
SPBF were required to recognize income, how should its character be
determined? If inside basis were reduced, how should the decreases be
allocated?2"' And if more than one asset were distributed, or some
combination of money and assets, how should the distributee's outside basis
be allocated among the properties received? 282 It seemed unlikely that these
and other questions could be satisfactorily resolved without a degree of
complication inconsistent with the goals of the SPBF system.

In contrast, application of the proposed general rule for distributions
would seem to provide the taxpayer with a perfectly acceptable result:

Example 6. Same facts as example 5, except that the SPBF elects out
of the special exception. Under the general rule for distributions, the
SPBF must recognize $120 in capital gain on the liquidating
distribution and such gain is passed through to A, increasing outside
basis to $270. Thus, A would also recognize a $120 capital loss on
the distribution, which would offset the $120 passthrough gain. A
would receive a fair market value basis of $150 in the asset distribut-
ed.

This result is exactly the same as the one that would have been obtained by
A had the transaction involved the straight purchase and sale of the asset with
B.

Although an election introduces its own complexities, it would seem
to be the simplest solution in this case. The "mere change in form" exception
is intended as a relief provision and where it produces an undesirable result,
taxpayers should be provided with a way out of it. Failure to provide an
explicit election would simply give advantage to the well-advised who would
"elect" out in a transactional manner. Because in most cases, however, the
exception would be advantageous to taxpayers, the proposal provides that
taxpayers must affirmatively elect out of the exception.

279. See IRC § 732(b).
280. Under partnership law, if a § 754 election is in effect, the partnership would

have to reduce its basis in other assets by the $120. See IRC § 734(b)(2)(B).
281. Under partnership law, basis reductions must generally be allocated to

partnership property of "like character" to the property distributed, although there are
anomalies in the allocation process. See IRC § 755.

282. The partnership law rules are provided by § 732(c), as amended in 1997.

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The Future Taxation of Private Business Firms

iv. Other Rules Not Included.-In view of the
proposed rules for SPBF contributions and distributions, sections
704(c)(1)(B), 737, and 731(c) are unnecessary and not included in the SPBF
system. Although section 751(b) is not made completely superfluous by the
proposals-for example, a non-pro rata cash distribution might trigger tax
consequences under that provision but not under existing subchapter S-it is
also not included in the SPBF system. Discussion of section 751(b), however,
as well as whether sections 724 and 735 and the collapsible corporation rules
should be included in the SPBF system, is included in a following section.

Certain highly publicized transactions continue to justify the need for
effective disguised sale rules. 3 In addition, at a much less publicized level,
there appears to be widespread noncompliance in that area. In a recent poll,
a cross-section of accountants were asked to identify their prime targets for
IRS audit if they were to receive compensation equal to a percentage of any
additional tax discovered. Somewhat astonishingly, the "use of partnerships
to defer taxation of disguised sales" was among the top five targets identified,
along with such common areas of noncompliance as nanny tax situations and
disguised dividends.'

The need for disguised sale rules is much reduced in the SPBF
system. To the extent the transaction involves a property transfer to or
distribution from an SPBF which is taxable under the proposed rules for
contributions and distributions, a disguised sale transaction obviously does not
work. Another common technique is to use special allocations to effect the
disguised exchange of economic interests but the SPBF rules specifically
restrict the availability of special allocations.'

But the need for anti-disguised sale rules in the SPBF system is not
completely eliminated. For example, a contribution of appreciated property
to an SPBF by an owner with a sufficient interest in the firm might be
followed by a cash distribution to the transferor not exceeding the transferor's
basis in the property contributed. If respected, both transactions would be tax-
free under the SPBF rules (as well as under existing subchapter S) even
though they may together constitute the economic equivalent of a partial sale
of the property contributed. Another possible disguised sale opportunity under
the proposals is where both a contribution and distribution of property are

283. See Lee A. Sheppard, Using LLCs for Disguised Dividends, 76 Tax Notes
1524 (Sept. 22, 1997) (describing attempted tax-free sale of hundreds of millions of dollars
worth of Times Mirror stock through use of disguised sale technique with an LLC).

284. See Burgess J.W. Raby & William L. Raby, Tax 20 Forum: An Audit "Hit
List," 75 Tax Notes 105 (Apr. 7, 1997).

285. The proposal does allow an SPBF to have preferred interests. However,
preferred returns are less likely to cause concern under the disguised sale rules. See Regs.
§ 1.707-4(a)(2).

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tax-free due to the transferor and the distributee having a sufficient ownership
interest in the SPBF.

On balance, the reduced need for disguised sale rules in the SPBF
system does not justify retention of such complicated provisions, and they are
not included in the SPBF system. In the two cases just described, normal step
transaction and other substance over form principles should adequately protect
the interest of the fisc. For example, a cash distribution linked to a prior
contribution of appreciated property should be considered boot received in the
initial transaction which will cause the recognition of gains.28 6 Although
there is no doubt that some disguised sales will escape recharacterization
under substance over form principles, it would appear that, as described
above, the more elaborate partnership rules have also not been wholly
effective. Finally, we again take some solace in the fact that subchapter S has
managed to function without any such rules.

v. Relation to Default Conduit System.-Finally, the
proposed income recognition rules for contributions and distributions within
the SPBF system must be compared to the taxation of comparable transac-
tions under the default conduit version. For example, if the default version
were to include the partnership nonrecognition provisions on contributions
and distributions, taxpayers might be discouraged from using the SPBF
system.

The various factors described above concerning the proper contribu-
tion and distribution rules are applicable to the default system as well as the
SPBF system. Although simplification may be a higher priority for the SPBF
system, it is certainly an important consideration for the default system as
well. Further, no system benefits from a rule structure which can be easily
manipulated by the taxpayer. And the default system is particularly vulnerable
to potential manipulation because of the absence of any ownership restrictions
and limitations on special allocations. In short, perhaps the easiest way to
reconcile the two systems in this area would be to adopt the same basic rules
in each system for contributions and distributions. The need for additional
rules may then vary depending upon the peculiar features of each system.

4. Treatment of Ordinary Income Assets of an SPBF

a. Sections 751 and 341 Not Included in the SPBF
Rules.-The partnership provisions contain elaborate rules to insure that a
partner's interest in potential ordinary income of the partnership is reflected

286. Cf. IRC § 351(b). See Berger, supra note 63, at 151-52 (suggesting that the
step transaction doctrine would prevent the transaction from succeeding).

[Vol. 4:3



The Future Taxation of Private Business Firms

in the character of the gain the partner recognizes in disposing of an interest
in the partnership.' These rules also try to prevent character shifting
among the partners as a result of a distribution.' On the other hand, if the
correct proportion of ordinary income and other assets (determined by value
of the assets) is distributed, no attempt is made to be sure that the assets
distributed have the same mix of unrealized ordinary income or loss as the
underlying assets of the partnership.'

These "collapsible partnership" rules governing the treatment of
ordinary income assets held by a partnership are among the most complicated
in the Code. Moreover, unlike rules such as Subpart F in the foreign tax area
or the consolidated return regulations, these rules apply to many taxpayers
with very simple business arrangements and relatively unsophisticated
advisors. The result, not surprisingly, is a common assumption that these
rules are often honored in the breach.

The collapsible partnership rules apply to transfers of partnership
interests and to distributions from partnerships. The rules governing transfers
are in some ways easier to understand than the rules governing distributions.
They essentially insure that the transfer of a partnership interest be viewed as
a transfer of the underlying assets in order to preserve the character of gain
or loss inherent in the transfer. But the rules governing distributions are of
equal importance in preventing the use of the partnership structure to avoid
the proper characterization of income at the partner level. It would not be
possible to adopt the rules for transfers without some rules for distributions.

As previously described, a distribution of property by an SPBF would
be taxable in more instances than a comparable distribution by a partnership.
This change reduces but does not eliminate the theoretical need for a
collapsible partnership rule in a distribution. For example, a non-pro rata
distribution of cash by an SPBF with ordinary income assets would generally
not be taxable under the SPBF proposal yet it may shift some of the potential
ordinary income tax liability from one owner to another.

Some of the complexity of the collapsible partnership rules derives
from the broad definition of assets that are covered by the rule. Although the
statute speaks of unrealized receivables and either inventory (in the case of
transfers of partnership interests29 ) or substantially appreciated inventory
(in the case of distributions29 ), the provisions apply to portions of assets
and to expectancies in a way that only a well-advised firm could possibly be
expected to follow.

287. See IRC § 751(a).
288. See IRC § 751(b).
289. See McKee, Nelson & Whitmire, supra note 202, 21.01[2] at 21-6 - 21-7.
290. See IRC § 751(a)(2).
291. See IRC § 751(b)(1)(A)Cii).

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Florida Tax Review

But the complexity of the provisions goes beyond those details
because they require taxpayers to trace through the consequences of
complicated transactions that are created by the statute alone. It is hard to
imagine such a structure being applied correctly by any but the most well-
advised taxpayers.

S corporations are not subject to the collapsible partnership rules. On
the other hand, they are subject to the infamous "collapsible corporation"
rules (section 341), which the American Law Institute has previously
described as "characterized by a pathological degree of complexity, vagueness
and uncertainty." '292 Where it applies, section 341 treats as ordinary income
any capital gain from the sale of an S corporation's stock or from a distri-
bution treated as a sale or exchange. 93 The provision is a close brethren of
the collapsible partnership rules, both in terms of purpose and complexity.

It therefore seems inevitable that neither of these rules will be
included in any simple regime such as the SPBF system. The question is
whether it is necessary to preserve some part of them in order to avoid abuse
of the SPBF structure. Consider the following example:

Example 7. Taxpayer G owns an asset with a significant amount of
unrealized ordinary income. G transfers the asset to an SPBF in
exchange for an ownership interest in the firm. G subsequently sells
the interest to H, recognizing capital gain on the sale.

One small way the proposed SPBF rules would prevent this
transaction is by restricting the instances in which G could transfer the asset
tax-free to the firm. A more important protection, however, is the ownership
limitations of an SPBF. To the extent the owners of an SPBF are in roughly
the same tax position, concerns that one taxpayer may avoid some tax at the
expense of another owner may be minimized. In other words, as long as the
issue is the proper allocation of income character among the owners, the
SPBF ownership rules may provide adequate protection without the need for
a special set of rules.

Thus, example 7 should not lead to major tax avoidance if H (and
any other owners of the firm) can be expected to pay tax at roughly the same
rate G would have been subject to.294 So long as the unrealized ordinary

292. American Law Institute, Proposals of the American Law Institute on The
Income Taxation of Corporate Acquisitions and Dispositions, A.L.I. Federal Income Tax
Project, Subchapter C 111 (1982).

293. See IRC § 341(a).
294. If H were not a permissible owner of an SPBF, then eligibility for the

simplified system would end with the sale. We have not worked out all of the consequences
of a transition from the SPBF system to the default conduit system, but presumably one

[Not 4:3



The Future Taxation of Private Business Firms

income remains in the SPBF following the sale, some future owner will have
to pay tax on it. As described in the next section, no inside basis adjustment
is authorized upon sale of an SPBF ownership interest. Thus, any unrealized
income of the SPBF should ordinarily remain inside the firm following such
a sale. Indeed, under those circumstances, one might even expect H's
purchase price for the ownership interest to reflect to some extent the lurking
ordinary income tax liability inside the firm.

A similar analysis applies to distributions. If a non-pro rata distribu-
tion of cash to one owner leaves behind a disproportionate amount of the
firm's ordinary income tax liability for another owner, one might presume
that the fisc will come out about the same if the two owners are in roughly
the same tax position.

In a rough way, Congress has shown acceptance of this theory
through enactment of section 341(f). In general, that provision allows a
shareholder to recognize capital gain upon the sale of stock of a collapsible
corporation on condition that the corporation recognize any unrealized
ordinary income at some future point in time. In other words, as long as
someone pays tax on the ordinary income--either the remaining shareholders
of an S corporation or the corporation itself in the case of a C corpora-
tion--the concern of the collapsible corporation rules is satisfied. Moreover,
unlike the protection offered by the SPBF ownership rules, the section 341(0
election is not conditioned on whether the ultimate taxpayer is in the same
tax position as the shareholder who sold the stock.'

To be sure, this Pollyannish approach to taxing SPBFs will not be
justified in every case. But even the full panoply of current subchapter K
does not prevent taxpayers from structuring transactions that fulfill the
requirements of the Code and yet appear to be inconsistent with the intent of
this subchapter.29 Furthermore, rules are only as effective as their
voluntary, correct observance by taxpayers or their proper enforcement by the
IRS, both of which being matters of serious doubt when it comes to
provisions such as the collapsible partnership and corporation rules. Although
some abuses will no doubt remain in the SPBF system, the goal of the

consequence would be the application of the normal default system rules to the terminating
transaction. Thus, if § 751(a) were part of the default system, it would potentially
recharacterize G's gain on the sale from capital gain to ordinary income.

295. The rule may, nevertheless, have that general effect. C corporations with
taxable income of $75,000 or more are taxed near the highest individual rates. And S
corporations have approximately the same ownership restrictions as an SPBF. Of course, the
§ 341(f) election is nonsensical in today's world with the repeal of General Utiities. the
taxpayer gets a benefit by having the corporation agree to do something--recognize corporate-
level income--which is already required by law.

296. See N.Y.S.B.A. Tax Section Report, supra note 67. See also Regs. § 1.701-
2(d), exs. 7, 8; Ti). 8588, 1995-1 C.B. 109 (preamble to original version of Regs. § 1.701-2).

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Florida Tax Review

structure is to balance the needs of the fisc with the desire to have a system
that can be applied by the taxpayers who elect to use it. Omitting the
collapsible partnership and corporation rules from the SPBF structure may
lead to the shifting of some ordinary income and capital gain among owners
of an SPBF, but should not lead to widespread tax avoidance. Accordingly,
sections 751 and 341 are not included in the SPBF system.

b. Character Continuation Rules.-A different issue
altogether arises if a transaction permits the conversion of ordinary income
into capital gain, rather than the mere misallocation of such items. The SPBF
ownership restrictions provide no protection against this advantage.

Conversion opportunities arise because, under the normal rule for
conduit taxation, the character of income is determined by the firm and then
passed through to the owners.2" Thus, an owner with an asset containing
unrealized ordinary income might contribute the asset to an SPBF in a tax-
free manner and then have the firm recognize the income. If the firm's
income were properly characterized as capital gain, the ordinary income tax
liability would be lost forever. Similarly, an SPBF holding an asset with
unrealized ordinary income might distribute the asset to an owner in a tax-
free manner. Again, if the distributee's recognition of the income were capital
gain, the ordinary income tax liability would be lost forever.

The proposed contribution and distribution rules for an SPBF narrow
the instances of this problem by restricting how often such transactions will
be nonrecognition events. But under the proposals, certain contributions and
distributions will still be tax-free. When they are, the ordinary income
character of an asset in the hands of the SPBF and the distributee following
a contribution and distribution, respectively, will be preserved. These rules are
embodied in current sections 724 and 735 applicable to partnerships. For the
SPBF system, those two rules are adopted but simplified by limiting their
application to traditional ordinary income items (e.g., inventory items and
accounts receivables) and ordinary income recapture items.

5. Inside Basis Adjustments

a. In General.-If a partnership makes an election under
section 754 of the Code, any transfer of an interest in the partnership results
in a set of adjustments for the transferee with respect to the bases of assets
held by the partnership; the adjustments will generally bring the bases of

297. See IRC §§ 702(b), 1366(b). The SPBF proposals follow this rule. See supra
Part IV.C.2.a.

[Vol. 4:3



77t Future Taxation of Private Business Firms

those assets attributable to the transferee closer to their fair market
values.298 Similarly, if a section 754 election is in effect at the time of a
partnership distribution, adjustments are made under section 734(b) to the
bases of the assets of the partnership to take account of any discrepancies
between the pre-distribution basis of any distributed asset in the hands of the
partnership and the post-distribution basis of such asset in the hands of the
distributee.29 The rules of subchapter S have no provision comparable to
section 754.

b. Adjustments Made on Distributions of Property.-In the
case of distributions of property, the adjustments made under section 734(b)
that are based on discrepancies between the pre-distribution inside basis of
property distributed and the post-distribution basis of such property in the
hands of the distributee are not necessary as a result of the proposed SPBF
treatment of distributions. Under that proposal, a distribution results either in
the recognition of gain or loss by the SPBF, with accompanying fair market
value basis to the distributee in the property distributed, or a pure transferred
basis to the distributee equal to the firm's pre-distribution basis.

Section 734(b), however, also applies when the distributee recognizes
gain or loss on a distribution and this situation could arise in the SPBF
system:

Example 8. A, B and C contribute $10,000 each to an SPBF and take
back equal shares of the firm. The firm purchases for $18,000 an
asset which increases in value to $24,000. At that time, the SPBF
distributes $12,000 to A in liquidation of A's interest. Under the
SPBF distribution proposal, A must recognize a $2,000 gain. If a
section 754 election were available and in effect, the basis of the
firm's asset would be increased by the $2,000 gain recognized by A.
Thus, if the asset is subsequently sold by the SPBF for $24,000, there
would be only $4,000 gain recognized, allocated $2,000 each to B
and C. Without that basis adjustment, the firm's gain on the sale
would be $6,000, allocated $3,000 each to B and C.

The failure to adjust basis if there were no section 754 election
available or in effect does not create a permanent mismeasurement of the
amount of gain or loss to be recognized by the remaining owners. In the
example above, absent a section 754 election, the $6,000 gain passed through
to B and C increases their outside bases by $3,000 apiece. If the SPBF were

298. See IRC §§ 743(b), 755.
299. See IRC §§ 734(b), 755.

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Florida Tax Review

liquidated at that time and each of them received a distribution of $12,000,
each would recognize a $1,000 loss. Thus, when there is no section 754
election made, the effect is on the timing of income.

Although there is no equivalent of section 751 in the SPBF rules, the
absence of a section 754 election will not affect the character of the income
recognized to the owners as a group. In the example above, if the asset
owned by the SPBF would generate ordinary income, A would nevertheless
recognize a $2,000 capital gain on the liquidation of the SPBF interest
(assuming it is a capital asset in A's hands). This is a consequence of the
absence of section 751. However, because there is no section 754 available,
the firm will recognize the full $6,000 gain as ordinary gain, and C, as well
as B, will have $3,000 of ordinary income as a result. Presumably, the parties
can take this into account in fixing a price necessary to liquidate A's interest.
Of course, if the asset had decreased in value, resulting in a distribution of
less than $10,000 to A, the effect would have been an acceleration of capital
loss (but no ordinary loss) to A, while B and C would have received an
allocation of more ordinary loss than they would strictly "deserve."

Section 754 elections make the conduit rules operate more precisely.
However, they do so in a way that involves substantial complexity for those
who must comply with the tax provisions. It seems likely that many SPBFs
would not rigorously apply the rules of sections 754 and 734(b) even if the
opportunity were available to them. Furthermore, the proposed distribution
rules for the SPBF system makes the election less necessary in the case of an
SPBF distribution than under subchapter K. In order to make the SPBF
system more manageable for those who elect it, no section 754 election is
provided for in a distribution.

c. Adjustments Made on the Sale of Ownership Inter-
ests.-When a section 754 election is in effect, upon a sale of a partnership
interest, the transferee receives special basis adjustments with respect to the
partnership assets attributable to the transferred interest.3" As a result, the
transferee is not required to pay tax on unrealized gain that the transferee has,
in effect, already paid for.

As with the adjustment on distributions, omitting the adjustment on
a sale changes the timing of the recognition of income:

Example 9. Same facts as in example 8, except that instead of
liquidating A's interest, A sells it to buyer D for $12,000, its fair
market value. A recognizes a $2,000 gain on the sale. If a section
754 election were available and in effect, D would receive a special

300. See IRC §§ 743(b), 755.

[Vol. 4.3



The Future Taxation of Private Business Firms

$2,000 upward basis adjustment with respect to the firm's appreciated
asset (one-third of the $24,000 fair market value less one-third of the
$18,000 basis). Thus, if the asset is sold by the firm for $24,000, D's
$2,000 share of the firm's $6,000 gain would be completely offset by
D's special $2,000 basis adjustment.

In example 9, when no section 754 election is in effect, D's $2,000
share of the gain on the sale of the asset results in a larger outside basis in
the firm. Thus, when D sells the interest in the firm, D will have less income
than had a section 754 election been in effect. The increased income at the
time the asset is sold is matched by decreased income when the SPBF interest
is sold.

Despite the benefits that the precision of section 754 affords in the
case of a transfer of ownership interests, the cost in terms of complexity is
quite great. Unlike the adjustments on a distribution which can be made to
the general basis of the firm, the basis adjustments on a sale are unique to
particular owners. In example 9, the $2,000 basis adjustment belongs to D
only; B and C would be taxed incorrectly if the general basis of the firm in
the asset were increased by $2,000 and the three owners subsequently split
equally the resulting $4,000 gain upon sale of the asset.~" In addition, if
the firm has many assets, the total basis adjustment must be allocated among
those assets. If there are multiple sales, it will have to keep track of separate
sets of such adjustments for different owners. Moreover, it will have to
remember to apply all of the adjustments correctly in calculating and
allocating gains and losses of the firm on future sales.

The timing problems that arise when no section 754 election is
permitted have been tolerated in the subchapter S context. Because of the
proposed SPBF distribution rules, there should be no permanent effect on the
amount of income recognized.

Not allowing a section 754 election can give individual owners tax
consequences that are not precise. However, those consequences can to some

301. But see Prop. Regs. § 1.743-2(a) allowing a special basis adjustment with
respect to only one partner to be taken into account as a general partnership basis adjustment
when partnership assets are deemed contributed to a corporation pursuant to an elective
conversion from partnership to association tax status. (Under Prop. Regs. § 301.7701-3(g)(l)(i),
if a partnership elects to be classified as an association for tax purposes, the partnership is
deemed to contribute all of its assets and liabilities to the association in exchange for stock in
the association, followed by an immediate liquidation of the partnership and distribution of
such stock to the former partners.) In the deemed contribution of assets to a corporation, the
corporation's basis in the assets contributed generally takes into account any special basis
adjustments belonging to individual partners. Prop. Regs. § 1.743-2(a). The individual partners
also preserve their special basis adjustments in determining their basis in the corporate stock
received in the exchange. Prop. Regs. § 1.743-2(c) (2d sentence).

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Florida Tax Review

extent be predicted at the time of a purchase, and, at least in theory,
adjustments can be made to the purchase price to accommodate those
consequences. In any event, the benefits of the simplicity of the SPBF system
should prove attractive enough to make taxpayers willing to adopt the SPBF
structure despite this imprecision.

The absence of the section 754 election also permits manipulation by
the owners of some of their tax consequences. But because section 754 is
elective under current law, that possibility already exists.2' True, the
absence of section 751 in the SPBF structure makes this manipulation
potentially more serious. Yet the manipulation is primarily a problem to the
fisc to the extent taxpayers with significantly different tax profiles are willing
and able to join together in an SPBF. If the SPBF qualification rules are
sufficiently stringent generally to prevent that phenomenon, the benefits of
the simplicity of the SPBF system outweigh the cost of an occasional abuse.

In summary, the SPBF system does not provide for inside basis
adjustments in the case of transfers of SPBF interests or distributions by an
SPBF.

6. Conversions/Reorganizations of Firms From One System to
Another.-The proposals described in this article would tax general business
firms in three ways. Private firms qualifying as SPBFs would be taxed at
their election under either the SPBF system or the default conduit system. All
other private firms would be subject to the default conduit system. Finally,
public firms would continue to be taxed under subchapter C. This section
sketches out some preliminary considerations in ascertaining the tax
consequences of a firm moving from one system to another. The movement
may occur as a result of an elective conversion (for example, an SPBF
electing to leave the SPBF system and to be taxed under the default conduit
system) or a reorganization of some sort (for example, a public firm acquiring
a private firm in a transaction qualifying as a reorganization under current
law).

a. Private Firm (Either SPBF or Default System) to Public
Finn (Subchapter C).-The movement from one of the private firm tax

302. See Regs. § 1.701-2(d), ex. (8) and (9) (describing manipulative possibilities
under current subchapter K if no § 754 election is in effect). The ACM Partnership transaction
also would not have worked had there been a § 754 election in effect. See supra note 88.
Strategic planning may help to prolong the benefit. Cf. Louis S. Freeman & Thomas M.
Stephens, Using a Partnership When a Corporation Won't Do: The Strategic Use and Effects
of Partnerships to Conduct Joint Ventures and Other Major Corporate Business Activities, 68
Taxes 962, 995 (1990). Finally, imprecision in the § 755 basis allocation rules creates planning
opportunities. See Andrews, supra note 67, at 25-37.

[Vol 4:3



The Future Taxation of Private Business Firms

systems to subchapter C involves a change from a conduit tax system to a
double tax system. As such, this type of transaction would seem to be a good
candidate for liberal tax-free treatment. Current law generally achieves this
result. For example, there are no tax consequences if a private C or S
corporation goes public; in the latter case, the corporation simply loses its S
eligibility and is thereafter taxed under subchapter C. In addition, both a
private C and S corporation may be acquired by a public corporation in a tax-
free reorganization.

Finns taxed under subchapter K cannot convert to public C status
quite as easily as private corporations, and cannot reorganize directly with
public C corporations, but they can accomplish the same general results with
adequate advance planning. For example, the IRS generally respects the form
chosen by the taxpayer for incorporating a partnership, with tax-free treatment
being the general consequence, although the specific tax results vary slightly
among the techniques.0 3 Once incorporated, the firm may go public or,
with sufficient delay, the former partnership may then participate in a tax-free
reorganization with a subchapter C corporation. Certain publicly traded
partnerships are also automatically treated as corporations for tax purposes
and taxed under subchapter C.30

4

While the substantive outcomes of firms moving from private C,
subchapter K, or subchapter S status to public C status are therefore alike, the
manner of achieving those results under current law are different. There does
not seem to be any good policy reason for preserving these differences, with
their accompanying increase in planning and transaction costs. Hence, this
article proposes generally to allow movement of a firm from the SPBF or
default conduit system to subchapter C to be accomplished in a tax-free
manner, whether the transaction is carried out as a conversion or reorganiza-
tion. Thus, for example, if an SPBF converts to public C status or is acquired
by a public C corporation in a transaction qualifying as a reorganization, and
in the process, the SPBF liquidates, no gain or loss should be recognized by
the SPBF or its owners in the liquidation.

303. Under Rev. Rul. 84-111, 1984-2 C.B. 88, if the partnership transfers its assets,
subject to its liabilities, to a new corporation and then liquidates, the transfer to the corporation
is governed by § 351 and the liquidation of the partnership is governed by § 731 and § 732
(taking into account the effects of § 752). If it liquidates, and then its partners transfer the
assets and liabilities to a new corporation, the liquidation is governed by § 731 and § 732
(taking into account the effects of § 752), and the transfer to the corporation is governed by
§ 351. If the partners transfer their partnership interests to a new corporation. which causes
the partnership to terminate as a matter of law, the transfer is governed by § 351 (taking into
account the effects of § 752), and the liquidation is governed by § 731 and § 732.

304. See IRC § 7704(a).

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Florida Tax Review

b. Public Firm (Subchapter C) to Private Firm (Either SPBF
or Default System).-In contrast to a private-to-public transaction, a public-to-
private transaction places the integrity of the double tax system in jeopardy
because all private firms are taxed under the proposal as conduits. When the
situation arises under current law, the double tax obligations are generally
either triggered in the transaction or preserved. For example, conversion of
a corporation into a partnership for tax purposes is treated as a taxable
liquidation of the former. 5 Conversion of a C corporation into an S
corporation gives rise to the potential applicability of the built-in gains and
passive investment income taxes under subchapter S.3"6 In general, those
two provisions authorize the subsequent taxation of the firm's accumulated
subchapter C earnings and profits and built-in subchapter C gains in certain
circumstances.

The built-in gains and passive investment income provisions,
however, offer incomplete protection for the double tax system. For example,
the built-in gains tax applies only when there is a net built-in gain in the
assets of the corporation at the time of the conversion. No attention is paid
to the likelihood of any built-in gains or losses being recognized in the future,
or to the character of such gains and losses. And exposure to the tax is
limited to a ten-year period. The passive investment income provision merely
attempts in a very rough way to limit the ability of a firm to delay the
shareholder tax on subchapter C distributions. In addition to being incom-
plete, both provisions also introduce undesirable complexity into the rule
structure.

A public-to-private transaction may be relatively infrequent but when
it occurs, it generally represents a fundamental change in the nature of the
firm. Currently, the tax system treats far less significant changes as taxable
events.307 It therefore seems appropriate to treat a public-to-private transac-
tion as a taxable event, thereby protecting better the integrity of the double
tax system and avoiding the complexity of provisions such as those found in
subchapter S. This rule would be similar to current proposals to treat

305. Proposed amendments to the check-the-box regulations adopt this approach if
the change in the tax status of the firm is made by election. See Prop. Regs. § 301.7701-
3(g)(1)(ii). Liquidation treatment occurs even though the corporation is a private C or
subchapter S firm.

306. See IRC §§ 1374, 1375. The S corporation is also more vulnerable to loss of
its subchapter S eligibility if the firm has a subchapter C history. See IRC § 1362(d)(3). These
rules apply regardless of whether the subchapter C corporation was public or private.

307. See, e.g., Regs. § 1.1001-3 (rules for determining whether a modification of
the terms of a debt instrument receives exchange treatment under IRC § 1001).

[Vol. 4:3



The Future Taxation of Private Business Firms

conversions of large C corporations into S corporations as complete
liquidations for tax purposes.3°s

One public-to-private transaction under current law--a public C
corporation going private but remaining under subchapter C-is not a taxable
event. Further, if the public-to-private change results merely from an
inadvertent crossing of the public/private line, the change may not even be
a very significant one for the firm.' The proposals do not provide a
comparable way to address this hardship case because they do not permit
private firms to be taxed under subchapter C. One narrow solution to this
problem is to allow any public firm which unintentionally becomes a private
firm to continue to be taxed under subchapter C for a period of time. During
that period, the firm could either regain public status, and thereby continue
under subchapter C, or make permanent its private status. In the latter case,
the normal consequences of a public-to-private change would then arise at the
end of the period.

c. Changing Tax Systems of Private Firms (SPBF to Default
System or Vice-Versa).-Under current law, the taxation of private firms
which change tax systems is not very coherent. For example, an S corporation
which converts to a partnership is treated as a taxable liquidation of the firm.
On the other hand, a partnership can generally incorporate and elect to be
taxed under subchapter S in a tax-free manner. Change from private
subchapter C status to one of the other tax systems implicates the double tax
features of subchapter C.

Under the proposal, all private firms are taxed as conduits, pursuant
to either the SPBF or default systems. Thus, changing from one system to
another, either by way of conversion or reorganization, could potentially be
a tax-free transaction. That conclusion, however, must be tempered by the
desire to protect the integrity of the rules of each system.

For example, the default conduit tax system, modeled after existing
subchapter K, will likely have a number of structures in them that are
intended to prevent abuse of that form. The SPBF structure does not include
those provisions in order to keep its operational rules relatively simple and
easy to work with. Thus, as previously described, the rules involving "hot
assets" and special allocations are not included in the SPBF system. If a non-

308. See Staff of the Joint Committee on Tax'n, 105th Cong., Description and
Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998
Budget Proposal 43 (Comm. Print 1977). The same proposal is included in the President's F'Y
1999 budget submission. President's Budget Proposals, FY 1999, 352 Table 8-6 (Effect of
Proposals on Receipts).

309. The public/private line under current law is set forth in § 7704(b) and the
regulations thereunder.

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Florida Tax Review

SPBF private firm could be transformed into an SPBF with no tax conse-
quences, it seems likely that the anti-abuse rules for the non-SPBF form
could be avoided.

Similarly, consider the taxation of a firm changing from the SPBF
system to the default conduit system. At first blush, this might seem to be the
most benign of possible transactions because the firm is leaving a system
with relatively few anti-abuse protections and entering one with many more.
On the other hand, the default conduit system will likely contain various
desirable tax features unavailable in the SPBF system. For example, the
default system will likely permit inside basis adjustments not allowed by the
SPBF system. A change from the SPBF to the non-SPBF system should not
allow a firm to gain one of these tax advantages without being subject to an
appropriate anti-abuse protection.

Example 10. A and B own an SPBF whose principal asset would
generate ordinary income if sold. There is a sale of ownership
interests from B to C. In the sale, B recognizes capital gain because
the SPBF rules do not have a section 751-type rule. This result
makes sense if C has more-or-less the same tax profile as B and steps
into B's shoes vis-a-vis the unrealized ordinary income of the firm.
C, however, is a nonresident alien and the sale therefore causes the
firm to lose its SPBF status and to be taxed under the default conduit
system. Under the default system, the firm makes a section 754
election which provides C with a special basis adjustment in the
ordinary income asset of the firm to reflect the gain recognized by B
on the sale. As a result, B's ordinary income liability is lost forever;
it is not recognized by B on the sale nor will it be recognized by C
in the future.

The precise tax consequences of private firms changing tax systems
under the proposal are somewhat up in the air as long as all of the details of
the SPBF and default conduit systems remain unsettled. However, the result
under example 10 should not be permitted. In general, firms would be entitled
to the benefits of the default system only if they are fully subject to the anti-
abuse protections of that system.

7. Transitional Considerations.-This section will briefly discuss
some transitional considerations to bridge the gap between current law and
the proposals presented in this article.

To help explain the development of the concepts, this article has
generally described the SPBF and default version of conduit taxation as
brand-new operating rule systems. In fact, however, the SPBF system is very
similar to existing subchapter S and the default system should be similar to

[VoL 4:3



The Future Taxation of Private Business Firns

existing subchapter K. Thus, existing firms subject to either subchapter K or
S should have little difficulty making the transition to the world presented by
these proposals. Upon adoption of these proposals, the firms will simply be
taxed under slightly amended versions of those subchapters.

Private firms currently taxed under subchapter C, however, face a
significant transitional problem because that subchapter would no longer be
available to such firms once the proposals are adopted. Moreover, the normal
consequence of the conversion of a subchapter C firm to one taxed under a
conduit tax system is a taxable liquidation of the former. It seems unlikely
that forcing all existing private C corporations to liquidate in a taxable
manner upon adoption of the proposals would either be appropriate from a
policy standpoint or feasible politically.

The transitional alternatives to an immediate taxable liquidation of
private C corporations run the gamut from (1) a permanent grandfather of all
existing private C corporations; (2) a temporary grandfather period during
which a liquidation must take place; (3) an immediate or deferred liquidation
with resulting tax liabilities to be paid over an extended period of time, or
with some reduction in the tax liability owed;3 0 (4) a tax-free conversion
to one of the conduit systems combined with rules such as sections 1374 and
1375 to preserve subchapter C gains; and (5) a tax-free conversion with no
preservation of subchapter C gains. A number of factors, including political
considerations, will help to decide which if any of these alternatives should
be implemented.

V. SUMM ARY AND CONCLUSION

As a result of recent federal and state law developments, the taxation
of private business firms is no longer rational. Existing law is built upon the
premise that business organizational form and characteristics are significant
for tax purposes. The recent developments, however, contradict that premise.
Consequently, the entire scheme of taxing private businesses, including the
current choices of subchapters C, K, and S for many private business firms,
must be rethought.

This article suggests that in the future, all private firms should be
taxed as conduits. Under conduit taxation, the firm is not taxed but the
owners of the firm are. Although conduit taxation is flawed in important
respects and is extremely complicated to implement, the alternative of taxing
the firm and not the owners may not be any better. Further, an entity tax

310. For example, any resulting gains might be taxable at a special low rate of tax,
or some portion of the gains might be exempted from tax altogether. This option might be
justified on the basis that most private C firms do not ever incur a full double tax on their
income.

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248 Florida Tax Review [Vol. 4:3

scheme would present greater transitional problems than widespread adoption
of conduit taxation.

Because conduit taxation is so difficult, this article further suggests
that it should be implemented in two versions. One version-a reformed
subchapter K-should concentrate on providing as precisely correct conduit
tax results as possible, even at the cost, if necessary, of some additional
complication. The other version-a liberalized subchapter S-should focus
on providing as administrable a set of conduit rules as possible with some
concession, if necessary, to not achieving the correct outcome in all cases.
Because the simplified conduit version would be elective to qualifying firms,
careful consideration of the substantive tax outcomes under the two versions
must be given to insure the continuing appeal of the simplified version.