476 조세연구｜제10—2집
Aggregate and Entity Approach in
Partnership Taxation
1)Lee,
Kang
[LLM(Taxation), UW School of Law, Expected June 2011. US. CPA(WA)]
Abstract
Taxing regimes of the United States are divided into three categories,
that is, taxation for corporation, partnership and individual. Because S
corporation and limited liability company (LLC) are basically taxed
through partnership taxation, a lot of taxable entities are regulated
under this taxation. It is difficult to apply because the Internal Revenue
Code(I.R.C.) has only 36 sections about that, but related regulations are
provided over about 250 pages.
Partnership taxation is supported by two theories, that is, aggregate
theory and entity theory. Aggregate theory is a kind of theory that states
that partnership is only equal to the aggregate of partners. According to
this theory, each partner is finally responsible for tax liability. In
contrary, entity theory is a kind of theory that states that partnership
exists separately regardless of its partners. Partnership taxation is
basically based on aggregate theory. However, because it is not easy to
establish a taxation system only with aggregate approach, both theories
* 투고일：2010.7.15., 심사개시일：2010.7.29., 수정일：2010.8.23., 게재확정일：2010.8.25.
Aggregate and Entity Approach in Partnership Taxation 477
are included in a lot of provisions. So, to summarize key points of
partnership taxation from the standpoint of aggregate and entity
approach is helpful to understand. This is also helpful when we need to
revise the provisions. Especially, because partnership taxation was
enacted as a title of “Special Taxation for Partnership Firms” and has
been effective since 2009 in South Korea, it is a task of great significance
at this time to review the partnership taxation horizontally according to
both theories.
In this article, I would like to review and compare the legal attitude of
U.S. law with Korean’s with respect to aggregate theory and entity theory
in partnership taxation.
Key Words：　Partnership taxation, Entity theory, Aggregate theory
Ⅰ. Introduction
There have been a lot of studies about partnership taxation in South
Korea. As a result of studies and changes of business environment,
partnership taxation was enacted under the name of “Special Taxation for
Partnership Firms” and has been in the process of enforcement since
2009. However, because current sections only provide basic structure, it is
expected that there will be a lot of confusion in the process of real
enforcement.
Partnership taxation is known for the most complicated taxation.
Although the Internal Revenue Code(I.R.C.) has only 36 sections,
regulation provides a lot of specific rules and examples over about 250
pages. Taxation of the United States is divided into three categories, that
478 조세연구｜제10—2집
1)
is, taxation for individuals, for corporations
2)
and for partnerships.
3)
However, as S corporation and Limited Liability Company (LLC) are
basically taxed through partnership taxation, partnership taxation has
applied to a lot of business entities.
4)
Partnership taxation is supported by aggregate and entity theory.
Aggregate approach is defined as if the entity is considered as an
aggregation of individuals. In contrary, entity approach is defined as if the
entity is separate from individuals. Basically, partnership is not a taxable
entity. This means that partnership needs not to pay tax liability. All
income and loss items are finally passed through to partners, and partners
will be responsible for paying tax liability. The Code allows a freedom
and flexibility to partnership. However, it is also an element that makes
1) Although there are a lot of differences between the corporate taxation and the
partnership taxation, major difference is that the corporate taxation reflects entity
theory. See the following for the detailed explanation. Boris I. Bittker and James
S. Eustice, Federal Income Taxation of Corporations and Shareholders, WG & L,
2009, ¶1.07.
2) S corporation is a pass-through entity. S corporation itself is not subject to tax
liability. In 1997, tax return by S corporation exceeds more than 50% of the
corporate tax return for the first time. In 2003, tax return by S corporation occupies
61.9% of the total corporate tax return. See the following for the details. Stephen
A. Lind et al., Fundamentals of Partnership Taxation, Foundation Press, 2008,
pp.27~28.
3) Id. at 28.
Limited liability company (LLC) appeared in the 1980’s and has become the best
alternatives for a closely held business. The number of LLCs was 118,559 in 1995.
However, it increased up to 1,465,223 in 2005.
4) In fact, the combination of both theories started from enactment of the original
Uniform Partnership Act (UPA) in 1914, prior to tax aspect. See following article
for detail. Daniel S. Kleinberger, The Closely held business through the entityaggregate prism, 40 WFLR 827, at 827.
Aggregate and Entity Approach in Partnership Taxation 479
it complicated. Because all items are taxed under the individual level, it
is a key point to understand how the basis changes, especially outside
basis. These structures reflect aggregate theory. It is helpful to understand
both approaches and catch up with them over partnership taxation.
Although there are a lot of articles only to explain partially current
position in each section as results of prior research, there are a few
articles to analyze both theories specifically and insist on a specific
theory. A recent article, “Aggregate-Plus Theory of Partnership Taxation”
(2009) by Professor Borden at Washburn University School of Law shows
how both theories are realized into partnership taxation. It is a very useful
article for understanding basic positions although Professor Borden also
does not insist on choosing a specific theory.
In this article, I would like to review and compare the legal attitude
of I.R.C. with Korean’s current act with respect to aggregate theory and
entity theory in partnership taxation.
Ⅱ. Formation
1. The legal attitude in I.R.C.
(1) Non-recognition and basis.
When it comes to partnership formation, any gain or loss on the
transfer of property to a partnership is not recognized for the contributing
5)
6)
partner and partnership although there is an exception. It is a natural
5) I.R.C. §721(a).
6) I.R.C. §351(a). and Reg. §1.351-1(c)(1)(ⅱ). §351(e) prevents an investment com-
480 조세연구｜제10—2집
outcome because partnership is not a taxable entity according to aggregate
approach. It is mere conversion from the partner’s prior property to the
partner’s interest. Although there is no section setting forth what is a
property for §721, The Court held that the term ‘property’ for §351 is
7)
analogous to the term ‘property’ for §721.
The Court also held that
services are not included in the term ‘property’ here. So, contribution of
services is a taxable event, and the partner has to recognize gain, if any
8)
gain. Unlike formation of C corporation, §721 doesn’t require to control
of the partnership immediately after formation.
Through the formation, a contributing partner transfers his original
9)
basis to the partnership. So, a partner’s basis in partnership interest is
equal to the sum of any cash contributed and the adjusted basis of the
contributed property. It is generally referred as “outside basis”, and
outside basis reflects the aggregate theory. The partner is allowed to tack
the prior holding period to the holding period of partnership interest.
In contrary, through the formation, partnership gets to have its own
basis. It is generally referred as “inside basis”, and inside basis reflects
the entity theory. Partnership is also allowed to tack the partner’s holding
10)
period.
pany from converting investment items without recognition of gain.
7) Stafford v. United States, 611 F.2d 990 (5th Cir. 1980).
8) I.R.C. §36(c).
In case of the formation of C corporation, the Code requires to control of the
corporation. To meet the control requirement, one or more shareholder must own at
least 80 percents of the total voting power of all classes of stock entitled to vote
and at least 80 percent of the total number of shares of all other classes of stock
of the corporation.
9) I.R.C. §722.
10) I.R.C. §1223(2).
Aggregate and Entity Approach in Partnership Taxation 481
Section §702(b) provides the character of items constituting distributive share. The character of any items of income, gain, loss, deduction,
or credit included in a partner’s distributive share under separately stated
item provision
11)
is determined as if such items were realized directly by
the partnership, or incurred in the same manner as incurred by the
partnership. This reflects entity theory. However, Code requires special
characterization rules to prevent partner from converting ordinary income
into capital gain or capital loss into ordinary loss according to aggregate
12)
theory.
Unrealized receivables, inventory items and capital loss property are
included in this special rule. First, when a partner contributes an
13)
unrealized receivable,
any gain or loss that is recognized by the
partnership on the disposition of the unrealized receivable is treated as
ordinary items. The holding period of a partnership does not matter.
14)
Second, when a partner contributes inventory items,
any gain or loss
recognized by the partnership during the 5 year period is treated as
ordinary items. It is different from the unrealized receivable from the
point that it doesn’t have period limitation. Third, when a partner contri-
11) See footnote 53 for detail.
12) I.R.C. §724.
13) I.R.C. §751(c).
The term “unrealized receivables” includes any rights to payment for (1) goods
delivered, or (2) services rendered, or to be rendered.
14) I.R.C. §751(d).
The term “inventory items” means (1) property of the partnership of the kind
described in §1221(a)(1), (2) any other property of the partnership which would be
considered property other than a capital asset and other than property described in
§1231, and (3) any other property held by the partnership which would be
considered property of the type described above.
482 조세연구｜제10—2집
butes built-in loss property, any loss recognized by the partnership from
the disposition of that property within 5 year after contribution is treated
as a capital loss.
(2) Liability
15)
Sometimes, partners borrow money as the partnership’s liabilities
forming a partnership. The partnership has to allocate liabilities among the
16)
partners according to aggregate theory.
The increase of a partner’s share
of liabilities is considered as a contribution of money according to
aggregate theory. In contrary, the decrease of a partner’s share of liabilities is considered as a distribution of money. So each partner has to
increase or decrease the outside basis up to the extent of the increase or
17)
decrease of the partner’s share of liabilities.
However, how and what amount a partner can increase or decrease
15) Reg. §1.752-1(a)(4).
Liabilities are divided into “§1.752-1 liability” and “§1.752-7 liability”.
§1.752-1 liability is defined as a liability that (1) creates or increases the basis of
any of the obligor’s assets, (2) gives rise to an immediate deduction to the obligor
；or (3) gives rise to an expense that is not deductible in computing the obligor’s
taxable income and is not properly chargeable to capital. Recourse liability and
nonrecourse liability are included in this category. §1.752-7 liability is defined as
any fixed or contingent obligation to make payment without regard to whether the
obligation is otherwise taken into account for purposes of the Internal Revenue
Code. This liability includes debt obligations, environmental obligations, tort
obligations, contract obligations, pension obligations, obligations under a short
sale, and obligations under derivative financial instruments such as options,
forward contracts, futures contracts, and swaps. §1.752-7 liability is treated as
built-in loss property.
16) I.R.C. §752.
17) It is a major difference from S corporation. In case of S corporation, each
shareholder doesn’t need to increase outside basis. See I.R.C. §1367 for detail.
Aggregate and Entity Approach in Partnership Taxation 483
outside basis depends on the character of liabilities. In case of “recourse
liabilities”, partnership has to allocate those liabilities to the partner who
bears the “economic risk of loss”. Whether any partner bears the economic risk of loss or not is determined by who would be required to pay
18)
ultimately.
In determining who bears the economic risk of loss,
19)
regulation introduces a “constructive liquidation”.
Partnership can deter-
mine who bears the economic risk of loss according to this method liquidation. To illustrate, consider following simple example.
Example #1：　AB is a partnership of which A and B are general partners.
A and B contribute cash in the amounts of ＄700 and ＄300. After forming
a partnership, the partnership purchases an office building for ＄5,000 by
paying ＄1,000 cash and assuming ＄4,000 mortgage. This mortgage is fully
recourse. A and B agreed to share all profit and loss according to
contribution rate (7：3). AB’s original balance sheet is as follows：
Asset
Office building
Liabilities
＄5,000
Mortgage
＄4,000
Capital Account
A
B
＄700
＄300
＄1,000
18) Reg. §1.752-2(a).
19) Reg. §1.752-2(b)(1).
Under the constructive liquidation, all of the following events are deemed to
occur simultaneously；(1) All of the partnership’s liabilities become payable in
full；(2) all of the partnership’s asset, including cash, have a value of zero；(3)
the partnership disposes of all of its property in a fully taxable transaction for no
consideration；(4) all items of income, gain, loss, or deduction are allocated
among the partners；and (5) the partnership liquidates.
484 조세연구｜제10—2집
According to constructive liquidation, five events are deemed to occur
as follows：
(a) All of the mortgages become payable in full；
(b) Office building has a value of zero；
(c) Partnership disposes of the office building without consideration. This
results in a ＄5,000 loss；
(d) The ＄5,000 loss is allocated among A and B according to their
agreement, that is, ＄3,500 to A and ＄1,500 to B. This reduces their
capital accounts to (＄2,800) and (＄1,200).
(e) The partnership liquidates.
20)
2,800 and ＄1,200 stand for each partner’s share of liability.
A’s
outside basis increases from ＄700 to ＄3,500 and B’s outside basis
increases from ＄300 to ＄1,500.
It is a little different in the case of nonrecourse liabilities. A partner
doesn’t need to bear nonrecourse liabilities. So, constructive liquidation is
useless here. Instead, the partner’s share of nonrecourse liabilities is
21)
computed to sum three items：
22)
(a) Share of partnership minimum gain(PMG)；
20) A’s portion of liability is ＄2,800(＄4,000 × 70%) and B’s portion is ＄1,200
(＄4,000 × 30%). These amounts are added to A and B’s interest each.
21) Reg. §1.752-3(a).
22) Reg. §1.704-2(g)(1).
A partner’s share of partnership minimum gain equals (1) the sum of
nonrecourse deductions allocated to that partner up to that time and the
distributions made to that partner up to that time of proceeds of a nonrecourse
liability allocable to an increase in partnership minimum gain；minus (2) the sum
of that partner’s aggregate share of the net decreases in partnership minimum gain
plus their aggregate share of decreases resulting from revaluations of partnership
property subject to one or more partnership nonrecourse liabilities.
Aggregate and Entity Approach in Partnership Taxation 485
(b) The amount of any taxable gain that would be allocated to the partner
23)
under §704(c) and the regulations；
24)
(c) Share of the excess nonrecourse liabilities(excess NRL).
To illustrate, consider following simple example.
Example #2：　A, B and C formed ABC partnership. A contributed
＄200. B and C contributed ＄400 each. ABC borrowed ＄9,000 to
purchase an office building for ＄10,000. The useful life of the office
building is 5 years, and this building is depreciated on a straight-line
basis. Borrowed money was secured by the building. The partners share
all items in accordance with their capital contribution rate. Determine the
partner’s outside basis one year after forming a partnership.
In this case, the amount of first year depreciation is ＄2,000 and the
book value of the office building at the end of the first year is ＄8,000.
The amount of debt (＄9,000) exceeds the inside basis of property(＄8,000).
So, there is ＄1,000 partnership minimum gain. Second, there is no
§704(c) gain because this building is not contributed property. The
remaining ＄8,000 is an excess nonrecourse liability. Because all items are
allocated by capital contribution, outside basis is as follows：
23) Reg. §1.752-3(a)(2).
This gain is the amount allocated to the partner under §704(c) if the partnership
disposed of all partnership property subject to one or more nonrecourse liabilities
of the partnership in full satisfaction of the liabilities and for no other consideration.
24) Reg. §1.752-3(a)(3).
Excess nonrecourse liabilities are the remaining balance of nonrecourse liabilities
after prior allocation has been completed.
486 조세연구｜제10—2집
Amount
A
＄200
B
＄400
C
PMG
＄1,000
＄400
§704(c) Gain
－
－
－
－
Excess NRL
＄8,000
＄1,600
＄3,200
＄3,200
Share of liability
＄9,000
＄1,800
＄3,600
＄3,600
Initial OB
＄1,000
＄200
＄400
＄400
Final OB
＄10,000
＄2,000
＄4,000
＄4,000
※ ∙ PMG：Partnership Minimum Gain
∙ NRL：Non-Recourse Liabilities
∙ OB：Outside Basis
2. The legal attitude in South Korea
Restriction of Special Taxation Act does not provide any specific
provision for partnership formation. The current act only provides the
provision that listed firms which are established by other acts are eligible
25)
for partnership taxation.
For example, a partnership under the Civil Act or an undisclosed
association under the Commercial Act is eligible. So, it is ambiguous as
to which kind of positions the current act takes. This ambiguity gives the
current an act easy way to avoid considering the contribution problem.
The contribution under formation is one of the most difficult parts in
partnership taxation and it affects the whole process. Furthermore, the
contribution of property to company are taxed at the time of contribution.
This makes a lot of tax problems easier, but it also creates obstacles to
the vitalization of partnership taxation. The contribution of property
basically means the change of the character of investment, not amount of
25) Restriction of Special Taxation Act. §100-15.
Aggregate and Entity Approach in Partnership Taxation 487
property.
Although it is somewhat reasonable that the contribution of property
is taxed in the corporate tax law in the aspect that the corporate tax act
presumes the substance of corporation, it is not logically correct in
partnership taxation. It is reasonable that carryover provisions of realized
income through contribution of property, because all income and loss
except income and loss distributed are reflected into a partner’s interest,
and they are taxed in the final stages. This carryover provision also
triggers other problems when the partnership distributes contributed
property to a partner, or sells the property to a third party. However,
those problems may be solved according to the above examples of the
U.S. system.
Another major part with respect to the formation is about liability.
However, it is also ambiguous as to which kind of positions the current
act takes because the current act does not provide any specific provision
for dealing with liabilities when partnerships borrow money. The liability
problem relates to a partner’s interest. A general partner is generally
responsible for those liabilities. So, those liabilities are added to the
26)
partner’s interest. The adjustment of a partner’s interest
is one of the
major issues in partnership taxation. It is because of the adjustment of a
partner’s interest, that the partner’s interest affects the amount taxed at the
time of selling interest or liquidation. However, the current act only
provides for three cases, that is, (1) when partners contribute property, or
the partnership distributes property, (2) when partners purchase or sell the
interests of the partnership (including inheritances and gifts) and (3) when the
26) The current act uses the term, the adjustment of value of equity shares instead of
adjustment of partner’s interest. Restriction of Special Taxation Act. §100-17.
488 조세연구｜제10—2집
partnership allocates income or deficit. The provision for dealing with
liabilities is required because liabilities also affect the partner’s personal
interest and all income and loss are taxed at the ends through the
partner’s interest.
In conclusion for the formation, current act of South Korea is
deficient in most important provisions, that is, contribution and liabilities.
Ⅲ. Operation
1. The legal attitude in I.R.C.
(1) Income allocation
Partnership is not a basically taxable entity. So, all items, both
separately stated items and ordinary income or loss items are passed to
partners according to aggregate theory. Unless otherwise provided in the
Code, the distributive share of these items is determined by the
partnership agreement. This means that Code permits lots of flexibility to
partners and the partnership. This also means that through agreement
between partners, partners may distort tax results. So, if there are no
directions about the distributive share on the partnership agreement or the
allocation doesn’t meet the “substantial economic effects”, the distributive
27)
share is determined by interest rate of the partnership.
In conclusion, if an allocation from the partnership to each partner
has substantial economic effects, it will be respected. If not, the original
27) I.R.C. §704(b).
Aggregate and Entity Approach in Partnership Taxation 489
allocation will not be respected, and there needs to be reallocated in
accordance with the partner’s interest.
Substantial economic effects analysis is divided into two separate
tests, that is, “economic effects test” and “substantiality test”. First, we
need to determine if the allocation has economic effects. For economic
effect, a partner has to receive economic benefit or economic burden
28)
through allocation.
If the partnership agreement meets the following
29)
requirement, an allocation is deemed to have economic effects.
(a) Maintenance of the partners’ capital account in accordance with the
Regulation rules.
(b) Liquidating distributions are required in all cases to be made in
accordance with the positive capital account balance.
(c) If such partner has a deficit balance following the liquidation, that
partner is unconditionally obligated to restore the amount of such
deficit balance to the partnership.
Unlike general partnership, limited partnership can’t meet the above
third requirement because the limited partner doesn’t have an obligation to
restore the deficit. Regulation provides for “alternate test for economic
30)
effects”.
If the limited partnership agreement meets the following
requirements, an allocation is deemed to have economic effects.
(a) Above first and second requirements are satisfied.
(b) The partnership agreement contains a “qualified income offset”.
(c) The allocation does not cause or increase a deficit balance in such
partner’s capital account.
The second test is about substantiality to meet “substantial economic
28) Reg. §1.704-1(b)(2)(ⅱ)(a).
29) Reg. §1.704-1(b)(2)(ⅱ)(b).
30) Reg. §1.704-1(b)(2)(ⅱ)(d).
490 조세연구｜제10—2집
effects”. So, economic effects must be substantial. The economic effects
of an allocation are substantial if there is a reasonable possibility that the
allocation will affect substantially the dollar amounts to be received by
31)
the partners.
However, Code and regulation don’t give any specific
words about what cases are substantial. Instead, it provides two situations
that are not substantial, that is, “shifting tax consequences” and “transitory
32)
allocations”.
If at the time the allocations are the parts of the partnership
agreement, there is a strong likelihood that (a) the net increases and
decreases of a partner’s respective capital accounts will not differ
substantially from the net increases and decreases if the allocation were
not contained in the partnership agreement, and (b) the allocation will
33)
reduce the total tax liability of the partnership,
it is considered as case
of shifting tax consequences. To illustrate, consider following simple example.
Example #3：　A and B are general partners of AB partnership. The
partnership invested in municipal bonds, and received ＄500 of taxexempt interest from that bond. The partnership also received ＄500 in
cash from doing ordinary business. A is individually in the 35% tax
bracket, and B is in the 15% tax bracket.
If there is no special allocation, the partnership allocates ＄250 of
31) Reg. §1.704-1(b)(2)(ⅲ)(a).
32) Reg. §1.704-1(b)(2)(ⅲ)(c).
The transitory allocation is similar to “shifting tax consequence” method. Major
difference is that the transitory allocation is applied to taxable year between two
and five. If there is no offsetting allocation within 5 years, the allocation will be
respected.
33) Reg. §1.704-1(b)(2)(ⅲ)(b).
Aggregate and Entity Approach in Partnership Taxation 491
tax-exempt interest and ＄250 of ordinary income to A and B each.
34)
As
a result of this allocation, A has ＄412.5 of after-tax income, and B has
35)
＄462.5 of after-tax income.
So, total after-tax income is ＄875. If the
partnership allocates all tax-exempt interest to A, and all ordinary income
to B, then A has ＄500 of after-tax income, and B has ＄425 of after-tax
income. So, they have ＄925 of total after-tax income. This means that
through the special allocation, they receive an additional ＄50 benefit.
Therefore, the partnership has to reallocate these items.
(2) Allocation with respect to contributed property
Income, gain, loss and deduction with respect to contributed property
is shared by partners to take into account the variation between the basis
of contributed property and the fair market value at the time of
36)
contribution.
It is natural from the point of the aggregate approach
because only the partners are responsible for all items. If the tax basis of
contributed property is equal to the fair market value at the time of
contribution, it doesn’t matter.
However, if both amounts are different from each other, the
partnership must allocate built-in gain or built-in loss to the partners in
specific two cases. First case is when the partnership sells or exchanges
contributed property. Second case is when there is a depreciation or
34) It is because they are general partners and the allocation rate between A and B
is 50：50 if there is no special agreement. ＄250 of the tax-exempt interest and
＄150 of cash is allocated to A and B each.
35) A’s after-tax income is calculated like this：＄250(tax-exempt interest) ＋ ＄250
(ordinary income) × (100 － 35)% ＝ ＄412.5.
B’s after-tax income is calculated like this：＄250(tax-exempt interest) ＋ ＄
250(ordinary income) × (100 － 15)% ＝ ＄462.5.
36) I.R.C. §704(c)(1)(A).
492 조세연구｜제10—2집
depletion of contributed property. Here, regulation provides three possible
37)
methods；traditional method,
38)
traditional method with curative allocation
39)
and remedial allocation method.
The purpose of the traditional method
with curative allocation and the remedial method is to get rid of distortion
40)
from the ceiling rule.
To illustrate, consider following simple example.
Example #4：　A and B form AB partnership. A and B agree that all
profits and losses are allocated equally. A contributes a machine for
business with fair market value of ＄1,200 and the basis of ＄400. B
contributes land with fair market value of ＄1,200 and the basis of ＄200.
B has held this land for 5 years.
Situation 1：　suppose that the partnership sells the land immediately
after formation for only ＄600. What happens if the traditional method is
used?
37) Reg. §1.704-3(b)(1).
The traditional method requires that when a partnership has income, gain, loss
or deduction attributable to section 704(c) property, the partnership must make
appropriate allocations to its partners to avoid shifting the tax consequences of the
built-in gain or built-in loss.
38) Reg. §1.704-3(c)(1).
The curative allocation is an allocation of income, gain, loss or deduction for
tax purposes that differ from the partnership’s allocation of the corresponding
book item.
39) Reg. §1.704-3(d)(1).
The remedial allocation method requires to eliminate the distortions by creating
remedial items and allocating those items to its partners.
40) Reg. §1.704-3(b)(1).
According to the ceiling rule, all items allocated to its partners can’t exceed the
total partnership income, gain, loss or deduction.
Aggregate and Entity Approach in Partnership Taxation 493
The initial balance sheet after formation is as follows：
Asset
Tax
Book
Capital Acc’t
Tax
Book
Machine
＄400
＄1,200
A
＄400
＄1,200
Land
＄200
＄1,200
B
＄200
＄1,200
＄600
＄2,400
＄600
＄2,400
Because there is a tax gain of ＄400(＄600－＄200) and a book loss
of ＄600(＄600－＄1,200), a ＄400 tax gain has to be allocated to B
41)
according to §704(c),
and the book loss has to be allocated equally.
Basically, A should be allocated a ＄300 tax loss due to book loss.
However, because of the ceiling rule, that is, there is no tax loss in this
sale of land, A can’t be allocated a ＄300 tax loss. Balance sheet after the
sale of land is as follows：
Asset
Tax
Book
Capital Acc’t
Tax
Book
Machine
＄400
＄1,200
A
＄400
＄900
Cash
＄600
＄600
B
＄600
＄900
＄1,000
＄1,800
＄1,000
＄1,800
Situation 2：　suppose that the basic information is same as Situation 1,
and the partnership also has ＄1,000 of capital gain resulting from
business operation at the end of the first year. What happens if the
traditional method with curative allocation is used?
＄1,000 of capital gain is allocated equally. Because there is a ＄600
of capital loss in situation 1, the book value will finally be ＄1,400.
However, for tax purposes, A must not get a ＄300 tax loss resulting
41) §704(c) requires that the built-in gain related to §704(c) property must be
allocated to the contributing partner.
494 조세연구｜제10—2집
from the sale of land because of the ceiling rule. So, A’s share is reduced
to ＄200 from ＄500. Balance sheet in this situation 2 is as follows：
Asset
Machine
Cash
Tax
Book
Capital Acc’t
＄400
＄1,200
A
＄600
Tax
＄1,400
Book
＄1,600
＄1,600
B
＄1,400
＄1,400
＄2,000
＄2,800
＄2,000
＄2,800
Situation 3：　suppose the same with case. What happens if the
remedial allocation method is used?
In the remedial allocation method, if the allocation of tax gain or loss
is prohibited from following book items for noncontributing partners, then,
the partnership creates remedial tax items for the noncontributing partner
and offset tax items for the contributing partner at the same time. In this
case, because of the ceiling rule, A can’t receive the allocation of ＄300
tax loss. So, the partnership creates ＄300 capital loss for A, and at the
same time, creates ＄300 capital gain for B. Balance sheet in this situation
3 is as follows：
Book
Capital Acc’t
Tax
Book
Machine
Asset
＄400
Tax
＄1,200
A
＄100
＄900
Cash
＄600
＄600
B
＄900
＄900
＄1,000
＄1,800
＄1,000
＄1,800
These allocations become more complicated if there is depreciation
from the property. However, basic logic is equal to the above.
(3) Transaction between partnership and partner
A partner may receive a compensation for the service. If we adopt the
aggregate approach, it doesn’t make sense. How can the partner be
Aggregate and Entity Approach in Partnership Taxation 495
employed by that partner? If the partner sells or buys property, how can
we explain that situation according to the aggregate approach?
The Code has split this compensation issue into three categories. First,
if the partner provides service at arm’s length, that partner is not
considered as a partner. So, this compensation is treated as if it were a
42)
transaction with strangers.
This reflects entity theory. Second, if the
partner acts in the partnership’s capacity, this compensation is treated as
a part of the distributive share. So, it is taxed under §704(b) and general
rules of partnership taxation. This reflects aggregate approach. Third, if
43)
the partner receives a guaranteed payment,
approach.
the Code adopts a hybrid
44)
Sale or exchange of property between a partnership and apartner is
considered as if it were the transaction between a partnership and
45)
strangers.
However, for the purpose of preventing tax avoidance, the
Code provides that no deduction is allowed with respect to losses from
sale or exchange of property between a partnership and a partner owning
directly or indirectly more than 50% of the capital interest, or the profit
46)
interest.
The Code also provides that any gain from the sale or exchange
42) I.R.C. §707(a).
43) Reg. §1.707-1(c).
The guaranteed payment is a fixed payment for services when apartner provides
services as a partner or for the use of capital.
44) I.R.C. §707(c).
The hybrid approach means that it treats partnership as an entity for some
purposes, and as an aggregate for others. In this section, for the purpose of
§§61(a), 162(a) and 263, that the payment is treated as if it were a transaction
with strangers according to the entity approach. For other purposes, it is treated
as a distributive share according to the aggregate approach.
45) I.R.C. §707(a)(1).
46) I.R.C. §707(b)(1).
496 조세연구｜제10—2집
between a partnership and a partner owing more than 50% of the interest
47)
is considered as ordinary income.
(4) The sale of a partnership interest
Theoretically, entity theory treats the sale of a partnership interest as
a corporate stock. Therefore, any gain or loss from that sale is treated as
a capital gain or loss. Under entity theory, there is no effect on the
partner’s basis. In contrary, aggregate theory treats that sale as the sale of
an undivided interest in each asset. It has affected the character of gain
or loss. This means that gain or loss may become ordinary income or
loss. Furthermore, the buyer receives assets at a cost basis.
The position of the Code is not easy to understand at a first sight.
The Code ostensibly looks like adopting the entity theory because gain or
loss from that sale is characterized as capital gain or loss,
49)
doesn’t affect the inside basis of those assets.
48)
and that sale
This position also provides
50)
“administrative convenience” with the IRS.
However, §751 restricts application of §741 in specific case. So, the
amount of any money from the sale or exchange of unrealized receivables
or inventory items is considered as ordinary items. Additionally, if a
partnership makes a §754 election, the basis of partnership property is
adjusted in the case of a distributed property and a transfer of interest in
51)
the manner provided in §743.
So, the aggregate approach is also
47) I.R.C. §707(b)(2).
48) I.R.C. §741.
49) I.R.C. §743(a).
50) Bradley T. Borden, Aggregate-plus theory of partnership taxation, 43 GALR 717,
766.
51) These adjustments are for reducing the disparities between buyer’s outside basis
Aggregate and Entity Approach in Partnership Taxation 497
reflected strongly in this subject.
2. The legal attitude in South Korea
Basic concepts about income and loss allocation in the current act are
similar to I.R.C. So, all incomes are taxed in a partner’s level according to
52)
aggregate theory.
The income and loss are allocated in proportion to the
allocation rate at the end of each taxable year. Unlikely to I.R.C., the current
act divides the partner concept into two categories, that is, general partner
53)
and passive partner. No deficit is allocated to the passive partner.
54)
current act provides that the allocation rate of income and loss
The
applies to
the submitted allocation rate first, and then to the contribution rate.
However, there is no provision governing the special situation of
when the partner changes the allocation rate for the purpose of reducing
55)
taxable income.
So, there needs to be a special provision for preventing
the reduction of taxable income by changing the allocation rate. As we
saw in the above U.S. cases of partners changing their allocation rate,
partners have a chance to avoid or reduce potential income tax through
and share of inside basis.
52) Restriction of Special Taxation Act. §100-18.
53) A passive partner is a partner who has not participated in its management and two
restrictions have to be kept by the Presidential Decree. Firsts, his name should not
be used as a partnership name. Second, this kind of partner should not bear on
unlimited liabilities. Restriction of Special Taxation Act. Presidential Decree
§100-18.
54) The current act uses deficit instead of loss. Restriction of Special Taxation Act.
§100-17.
55) Restriction of Special Taxation Act, Presidential Decree. §100-17. Presidential
Decree only provides for general provision to prevent an unfair practice.
498 조세연구｜제10—2집
the change of their allocation rate. It is ambiguous as how to the extent
of those situations are respected when partners periodically change the
allocation rate. Although those situations can be finally resolved by suit,
it will be desirable to provide some specific guidelines to eliminate or
reduce disputes previously in the process of enforcement.
With respect to transactions between partnership and partner, the
current act provides that partnership and its partner each should include
income or loss in calculating tax liabilities if a partner makes a transaction
56)
with the partnership as a third party.
This position reflects entity theory.
Unlikely to I.R.C., the current act does not divide transactions specifically.
Instead, if a partnership or a partner understates the income dishonestly,
this transaction may be cancelled.
If a partner transfers partnership interest to the other person, income
57)
from this transfer is treated as income from general stock transfer.
This
position comes from entity theory. When we calculate income from an
interest transfer, the interest amount at the date of transfer becomes the basis.
Ⅳ. Distribution
1. The legal attitude in I.R.C
Theoretically, because a partnership is not taxable entity, all assets of
the partnership are owned by each partner. This means that a partner
56) Restriction of Special Taxation Act. §100-19.
57) Restriction of Special Taxation Act. §100-22.
Aggregate and Entity Approach in Partnership Taxation 499
doesn’t need to realize gain or loss even if the partnership distributes its
assets to the partners. The Code basically adopts this logic. In the case of
distribution, each partner related to distribution basically doesn’t need to
58)
recognize gain or loss.
However, there are some exceptions. First, if the amount of money
received from distribution exceeds the partner’s outside basis, then that
partner has to recognize gain. Furthermore, because distribution reduces
the partner’s share of interest, constructive cash distribution also has to be
recognized as gain. For example, distribution of marketable securities is
59)
treated as cash distribution.
Second, if the partner’s interest is changed
by distribution of unrealized receivables and inventory items, the distribute
60)
partneralso has to recognize gain or loss.
Third, if any contributed
property is distributed directly or indirectly within 7 years of being
61)
contributed, the distributed partner also has to recognize gain or loss.
To
illustrate, consider following simple example.
Example #5：　A and B form a general partnership. A and B agree that
all items are shared equally. After formation, the initial balance sheet is
as follows：
Asset
Book
FMV
Cash
＄300
＄300
Inventory
＄50
Land
＄150
＄500
＄800
58) I.R.C. §731(a).
59) I.R.C. §731(c).
60) I.R.C. §751(b).
61) I.R.C. §704(c)(1)(B).
Capital Acc’t
Book
FMV
＄200
A
＄250
＄400
＄300
B
＄250
＄400
＄500
＄800
500 조세연구｜제10—2집
Situation 1：　what happens if the partnership distributes all cash
equally to each partner?
No gain is recognized by each partner because the amount of cash
distribution (＄150) doesn’t exceed the partner’s outside basis (＄250).
There is also no effect on partnership. Due to cash distribution, the
partner’s outside basis will be reduced to ＄100 each.
Situation 2：　What happens if the partnership distributes all cash of
＄300 to A and land to B?
A has to recognize ＄50 gain because the amount of cash distribution
(＄300) exceeds A’s outside basis (＄250). A’s outside basis is reduced to
zero. B doesn’t need to recognize gain from the distribution of land
because any gain is recognized only by cash distribution. B’s outside basis
is reduced to ＄100.
2. The legal attitude in South Korea
When a partnership distributes some assets to a partner, the current
act provides that excess amount to be treated as a dividend if the market
value of the asset exceeds the value of the partnership interest. This
position is very similar to I.R.C. and it is a natural provision from the
basic concept prospective of partnership taxation. However, the current act
restricts the loss situation. The current act only allows two cases as a loss
when the market value of the asset does not exceed the value of
partnership interest. The first is when a partnership is liquidated by
winding-up, merger or consolidation. The second is when a partner
withdraws from the partnership. If a loss is permitted, this loss is treated
Aggregate and Entity Approach in Partnership Taxation 501
as a loss from stock transfer.
However, these restrictions are not fair provisions in comparison with
gain situations. In case of a gain, all of the gain from all situations has
to be included in computing taxable income. In contrast, loss from just
two cases is acceptable. This provision is extremely favorable for tax
administration.
The current act is very easy in comparison with I.R.C. because the
property contributed is tax at the time of contribution, and basis is move
to the value of the time which is taxed. Maintaining original basis makes
distribution process difficult. However, contribution should not be taxed at
the time of contribution as I mentioned above. If we changed the current
act, a lot of complicate problems would appear and similar provision like
I.R.C. would be required.
Ⅴ. Accounting Matters
1. The legal attitude in I.R.C.
(1) Computing taxable income
In this chapter, we also confirm that aggregate and entity theory are
harmonious with each other. §701 is natural when we consider the essence
of partnership taxation. It explains tax results between a partnership and
its partners according to aggregate theory Partners not partnership shall be
liable for income tax. However, when we specifically compute taxable
income, Code adopts entity theory. Code provides that the taxable income
of a partnership shall be computed in the same manner as in the case of
502 조세연구｜제10—2집
62)
an individual.
This means that it needs to compute taxable income in a
partnership level. There are a lot of tax items to affect all partners the
same way. Ordinary income items and ordinary deduction items are
mainly included in this category. These items generally produce ordinary
income or ordinary loss. So, these items are recorded on page 1 of Form
1065 first, and then are passed through to partners according to allocation
rate.
However, there are some tax items to be considered in the partner’s
63)
level. These items are referred as “separately stated items”.
When we
consider separately stated items, we get to know that aggregate and entity
theory are combined together here. Each partner has each tax profile. Each
partner has his own ordinary income or capital gain. Each partner has a
different maximum tax rate. This is a basic characteristic of partnership
taxation. Separately stated items are items that bring different results
depending on the tax profile of each partner. So, those items are recorded
first on Schedule K, and then recorded on Schedule K-1 according to the
allocation rate of the partners.
62) I.R.C. §703(a).
63) I.R.C. §702(a).
Separately stated items are as follows：(1) gains and losses from sales or
exchanges of capital assets held for not more than 1 year(it means short term
capital gain), (2) gains and losses from sales or exchanges of capital assets held
for more than 1 year(it means long term capital gain), (3) gains and losses from
sales or exchanges of property described in section 1231, (4) charitable contributions, (5) dividends with respect to section of “Dividends Received Deduction”
and section constituting net capital gain, (6) taxes, described in section 901, paid
or accrued to foreign countries and to possessions of the United States, (7) other
items of income, gain, loss, deduction, or credit, to the extent provided by
regulations prescribed by the Secretary, and (8) taxable income or loss, exclusive
of items requiring separate computation under other paragraphs of this subsection.
Aggregate and Entity Approach in Partnership Taxation 503
There is a specific item that belongs to both ordinary items and
separately stated items. It is “guaranteed payment”. Guaranteed payment is
the amount that a partnership pays to a partner for the service and the use
64)
of capital without respect to the partnership’s income.
Because this item belongs to both categories, it is recorded on page
1 of Form 1065 as if the partnership pays to someone who is not a
partner, and then recorded on Schedule K and Schedule K-1 as ordinary
income. This means that it is regarded as expense on the partnership’s
level and ordinary income as on the partner’s level. Each partner who
receives guaranteed payments reports these payments on Schedule E(Form
1040) as ordinary income.
(2) Taxable year
This section about taxable year of partnership reflects entity theory.
The taxable year of a partnership is determined as though the partnership
65)
were a taxpayer.
A partnership has to follow the required taxable year
66)
except when the partnership establishes an acceptable business purpose,
67)
and it makes an §444 election.
First, the partnership has to adopt “Majority interest taxable year”.
Majority interest taxable year means the same taxable year used by that
partner or partners when one or more partner has an aggregate interest in
64) I.R.C. §707(c).
65) I.R.C. §706(b)(1)(A).
66) I.R.C. §706(b)(1)(C).
This business purpose is required for approval of the Secretary.
67) I.R.C. §444(b).
A partnership may elect under §444 to use different taxable year from required
taxable year only if the deferral period of the taxable year elected is not longer
than 3 months.
504 조세연구｜제10—2집
68)
partnership profits and capital of more than 50 percent.
If there is no
majority interest taxable year, the partnership has to adopt the same
taxable year of all principal partners if all principal partners share the
69)
same taxable year.
The principal partner is a partner owning an interest
of 5 percent or more in partnership profits or capital. If there is no
majority interest taxable year and principal partner’s taxable year, the
partnership has to adopt taxable year which results in the “least aggregate
70)
deferral of income”.
To compute least aggregate deferral of income,
Regulation requires testing each taxable year of all partners. After testing,
the taxable year that results in the least aggregate deferral of income
becomes the taxable year of the partnership. To illustrate, consider
following simple example.
Example #6：　ABC is a partnership of which A, B and C are partners.
Taxable year and profit allocation rate of A, B and C as follows：
Partner
Profits rate
Year end
A
B
C
40%
40%
20%
5/31
8/31
10/31
First, because no partner holds more than 50% and no combination of
partners share the same year, there is no majority interest taxable year.
Second, because A, B and C hold more than 5%, all are the principal
partner. However, the partnership can’t adopt the principal partner’s
taxable year because no partners share the taxable year. Third, to see the
least aggregate deferral of income, we need to test each taxable year of
68) I.R.C. §706(b)(4).
69) I.R.C. §706(b)(1)(B)(ⅱ).
70) Reg. §1.706-1(b)(3)
Aggregate and Entity Approach in Partnership Taxation 505
each partner.
Assuming the adoption A’s 5/31 fiscal year
Partner
Year end
Profits rate
Months of deferral
Rate × Deferral
A
B
C
5/31
8/31
10/31
40%
40%
20%
0
3
5
0
1.2
1.0
71)
Total 2.2
Assuming the adoption B’s 8/31 fiscal year
Partner
Year end
Profits rate
Months of deferral
Rate × Deferral
A
B
C
5/31
8/31
10/31
40%
40%
20%
9
0
2
3.6
0
0.4
72)
Total 4.0
Assuming the adoption C’s 10/31 fiscal year
Partner
Year end
Profits rate
Months of deferral
Rate × Deferral
A
B
C
5/31
8/31
10/31
40%
40%
20%
7
10
0
2.8
4.0
0
73)
Total 6.8
As we can see above, because adoption of 5/31 fiscal year results in
the least aggregate deferral of income (2.2), the partnership has to adopt
that taxable year ending 5/31.
71) This amount is calculated like this；(40% × 0) ＋ (40% × 3) ＋ (20% × 5) ＝ 2.2
72) This amount is calculated like this；(40% × 9) ＋ (40% × 0) ＋ (20% × 2) ＝ 4.0
73) This amount is calculated like this；(40% × 7) ＋ (40% × 10) ＋ (20% × 0) ＝ 6.8
506 조세연구｜제10—2집
2. The legal attitude in South Korea
The current act also reflects entity theory when we compute a
partnership’s income and aggregate theory when these incomes are
allocated to its partners. It is a basic concept of partnership taxation. In
case a partnership is not a type of corporation, this partnership is treated
74)
as a single domestic corporation in many cases.
It includes the taxable year, tax payment place, business registration,
tax credits, abatement and exemption of tax amount, tax withholding,
additional tax and transfer income of land. So, all accounting matters with
a partnership are handled through the entity theory. It is acceptable to take
this position for easy process for taxation. However, it is necessary to
provide a special provision to prevent avoiding tax liabilities. For example, the current act, mutatis mutandis, uses a taxable year provision of the
corporate tax act. It means the partnership may freely change the taxable
year according to the corporate tax act. At the end, income or deficit is
allocated to the partner according to the allocation rate at the end of year
75)
in which the taxable year of the partnership firm ends.
It gives partners opportunities to avoid or reduce income tax using a
different income tax rate. So, there needs to be some provisions similar to
a disapproval provision of an unfair practice. The current act also has
those provisions partially, that is, under transactions between the partner
ship and its partners
76)
or under the provision that non-resident or foreign
74) Restriction of Special Taxation Act. §100-26.
75) Restriction of Special Taxation Act. §100-18.
76) Restriction of Special Taxation Act. §100-19.
Aggregate and Entity Approach in Partnership Taxation 507
77)
corporation partners receive a dividend.
However, those provisions can’t
be applied to all unfair practices. Although it is perfectly acceptable to
enact specific provisions to prevent avoiding and reducing tax, it is an
alternative to maintain that provision for a while because it will be
specific and supplemented on the process of enforcement.
Ⅵ. Conclusion
I have reviewed basic sections and related regulations in four chapters
formation, operation, distribution and accounting matters. Aggregate and
entity theory are related to each other like a spider web. It is too much
78)
to say that almost all sections are related to both theories.
Throughout
history, there was a time that the aggregate approach was the focus, or the
entity approach was the focus. However, it is no more or no less for
computing appropriate taxable income and loss.
As I write above, partnership taxation was enacted and has been
effective since 2009 in South Korea. However, because it doesn’t have
enough provisions in Presidential Decree, It is expected that there will be
in a lot of confusions in the enforcement. There will also be a need to
revise current provisions in the near future. However, we don’t need to
stick to a specific approach. As we review the four points above, focusing
on entity or aggregate theory is not the important issue. The substance of
partnership taxation is to give a taxpayer more discretion. So, Enactment
77) Restriction of Special Taxation Act. §100-24.
78) Bradley, supra n. 46, at 784.
508 조세연구｜제10—2집
of any new provision should be done according to the direction that
appreciates the substance of this system well, not focusing on either
aggregate or entity approaches.
Finally, I hope that the National Tax Service (NTS) will have a
positive position in the new tax system. Partnership taxation may provide
good alternatives to choose taxable entity with taxpayers. NTS needs to
keep in mind that after decision of Internal Revenue Service(IRS) that
LLC is taxed under partnership taxation, LLC has become a common type
of taxable entity.
Aggregate and Entity Approach in Partnership Taxation 509
｜bibliography｜
Bittker, Boris I. & Eustice, James S., Federal Income Taxation of Corporations and Shareholders, WG & L. 2009.
Borden, Bradley T., Aggregate-plus theory of partnership taxation, 43 GALR
717, 2009.
Cunningham, Laura E. & Cunningham, Noel B., The Logic of Subchapter K.,
Thomson/west, 2006.
Donaldson, Samuel A., Federal Income Taxation of Individual, Thomson/west.
2007.
Gunn, Alan, & Repetti, James R., Partnership Income Taxation, Foundation
Press. 2005.
Kleinberger, Daniel S., Closely Held Business Through The Entity-Aggregate
Prism, 40 WFLR 827, 2005.
Lam, Edward W., The Treasury’s panacea against abusive partnership, 9
DPLBLJ 65, 1996.
Lind, Stephen A., et al. Fundamentals of Business Enterprise Taxation,
Foundation Press, 2008.
_______________, et al. Fundamentals of Corporate Taxation, Foundation
Press, 2008.
_______________, et al. Fundamentals of Partnership Taxation. Foundation
Press, 2008.
Staffaroni, Robert J., Partnership：Aggrgate vs. Entity and U.S. International
Taxation, 49 TAXL 55, 1995.
White, Matthew K., New tension between entity and aggregate theories of
partnership taxation, 3 No. 3 BUSNET 14, 2001.
510 조세연구｜제10—2집
국문요약
조합과세제도에서의 집합론과 단체론
미국의 과세제도는 크게 C corporation에 대한 과세, partnership에 대한 과세,
그리고 개인에 대한 과세로 나누어볼 수 있다. S corporation과 최근에 유행하고
있는 LLC도 약간의 차이는 있지만 기본적으로 파트너십 과세제도를 이용하고 있
기 때문에 널리 이용되고 있다. 파트너십 과세제도는 비록 조항 수는 36개 조밖에
되지 않지만, Regulation은 250여 페이지에 달하기 때문에, 적용시에 많은 어려움
이 있는 제도이다.
파트너십 과세제도는 크게 두 가지 이론, 즉 집합론과 단체론에 의해서 구성된
다. 집합론은 파트너십이 파트너들의 합일체에 불과하다는 이론으로서 결국적으
로 파트너 개인이 종국적인 납부 책임을 지게 된다. 이에 반해 단체론은 파트너십
이 파트너와는 별개의 단체로서 존재한다는 이론이다. 파트너십 과세제도는 개념
적으로 집합론에 근거한 과제제도라고 할 수 있다. 그러나 집합론 자체만으로는
적절한 과세체계를 확립하기가 어렵기 때문에 현실적으로 단체론에 근거한 규정
들이 상당수 혼재되어 있다. 따라서 이러한 집합론과 단체론의 관점에서 파트너십
과세제도를 바라보는 것은 그 자체로도 파트너십 과세제도를 이해하는 데 도움이
될 뿐만 아니라, 개별 사항에 대해 이를 입법적으로 어떻게 규율할 것인지를 판단
하는 데에도 많은 도움이 된다.
특히 우리나라의 경우 조세특례제한법에서 “동일기업에 대한 과세특례”라는 제
목하에 파트너십 과세제도를 도입하여 2009년부터 시행하고 있다. 따라서 집합론
과 단체론의 관점에서 파트너십 과세제도를 횡적으로 고찰해 보는 것도 이 시점에
서 의미있는 일이라 생각된다.
따라서 본 논문에서는 미국과 한국의 파트너십 과세제도를 설립, 운영 및 분배
와 회계문제로 나누어서, 각 부문에서 집합론과 단체론이 어떻게 영향을 미치고
있는지 살펴보고자 한다.
주제어：　파트너십 과세제도, 조합과세제도, 집합론, 단체론, 동일기업