Ways and Means Passthrough Reform Hearing Today Yields Little Substance

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There was a House Ways and Means passthrough tax reform hearing this morning, May 15, in Washington, D.C. Not much happened at the meeting. There was testimony that Option 1 of the Camp Passthrough Proposals was fine but that Option 2 of those proposals was even better, with some caveats. Then there was the opposite view expressed by another witness that Option 1 had some objectionable provisions in it and that Option 2 was even worse.

So much for consistency. There was no real discussion of the fact that economic accuracy in statutory drafting is complex and this objective directly competes with the tax policy goal of simplicity in drafting statutes. See my prior post on this issue, Passthrough Entity Tax Reform.

Other than complaints by one witness that the Option 1 and 2 tax reform proposals would increase the tax liability of the partners and would frustrate everyday common business transactions and was just too complex, there was no discussion at the hearing this morning of the tax policy surrounding the taxation of partnership appreciated property distributions to partners. There was also no discussion of any tax policy objectives of any of the other partnership proposals in Options 1 and 2. The truth be told (because I surely did not hear it from the testimony at the hearing today), the fact that appreciated property distributions by a partnership to its partners will increase the tax liability of the partners means nothing by itself. Businesses will adjust to this taxation regime, if it comes to pass. Rather, the key question is whether making it harder to exit partnerships on a tax-free basis, as compared to current law, is either a good policy choice or a poor one. Any overbroad aspects of these property distributions, once the tax policy goals are settled by the Congress, can surely be resolved in the statutory drafting process.

It is well known among partnership practitioners that current law allows appreciated property to escape current tax and even allows the tax-free shifting of some built-in gains on such properties among the partners. And so, not taxing these distributions allows this practice to continue. On the other hand, it could be that imposing this tax will cause hardship on at least some taxpayers-those who cannot afford high priced tax advice to find ways around the problem to be sure will be among those adversely impacted. The point is that one first needs to get the tax policy goals fixed before moving forward with this kind of proposal. I heard none of that at the hearing today. Maybe that will come at another hearing?

There were objections by one witness that mandatory basis adjustments, as is set forth in both of the Camp passthrough reform options, creates too much complexity. Well, that is true but the question again is whether the complexity, which is caused by the economic accuracy of that proposal, is worth making the Code more, and not less, complex. It was also stated by that witness that the so-called “three basket anti-special allocation proposal” (where allocations have to be in accordance with the partners’ economic interests in the partnership in the ordinary asset class, the capital asset class and the tax credit class) will disrupt common business transactions, and that current law section 704(b) and its underlying regulations are sufficient to prevent abuse. The first point I have addressed in my Tax Notes article on the subject, An Initial Look at Camp’s Small Business Proposals (March 18, 2013). The second point is, frankly, just plain silly. I do not think that any reasonable person could think that current law’s substantial economic effect test under section 704(b) and its very complex regulations adequately polices partnership allocations when many IRS agents and tax advisors, frankly, do not understand those regulations.

I do not know where this tax reform process will go. At least the Congress is holding hearings. But hearings alone are not enough. There will come a time, most likely very soon, when the decision will have to be made to move forward or not on tax reform. Given that reality, it is important that all of us let our views be known on these issues before it is too late.

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