Congress is debating the biggest rewrite of U.S. partnershiprules in 60 years, which may lead to higher taxes for real estateand finance businesses or prompt them to restructure operations toavoid new costs.

The more dramatic of two options from Dave Camp, the topRepublican tax writer in Congress, would remove some of theflexibility that has made partnerships attractive legal structuresfor real estate investors and hedge funds. He also offered analternative with lesser changes to simplify some rules and leavethe core of the current system in place.

The broader proposal surprised tax law specialists, who hadn'tanticipated a major policy shift for the 3.2 million U.S.partnerships. The plan may alter existing arrangements by making itmore difficult to allocate income and property among partnerswithout triggering tax consequences. Lawyers said they have spentthe past week scouring Representative Camp's draft bill, especiallyhis new second option.

“Option 2 is radical,” said Blake Rubin, global vice chair ofthe U.S. and international tax practice at McDermott Will &Emery in Washington. “It would be the most significant changes tothe partnership tax rules since their enactment in 1954.”

Real estate investors and hedge fund managers may restructurepartnerships to achieve the economic results they get in thecurrent system, perhaps by creating contractual arrangements toreplicate what the tax law would prevent.

When he released the proposal, Camp said he was seeking tosimplify the tax system and make the U.S. tax code more fair. Theproposal would change the rules governing what are known aspass-through entities — businesses such as partnerships that don'tpay taxes at the corporate level and instead pass their incomethrough to their owners' individual tax returns.

Camp's proposal is a “significant step in the right direction,”said Victor Fleischer, a partnership tax law professor at theUniversity of Colorado in Boulder who has criticized tax maneuversby private equity funds and other pass-through entities.

“Pass-through entities have, increasingly, been used tofacilitate aggressive tax gamesmanship,” Fleischer said in ane-mail. “Taxing pass-throughs should be about taxing all incomeonce and only once, not shifting income around to avoid paying anytax at all.”

Structural Changes

Camp, the chairman of the House Ways and Means Committee,released the draft as part of a plan to overhaul the U.S. tax code.The proposals affecting partnerships are the third in a series ofdrafts that would make structural changes to long-standing featuresof the tax code.

The first two drafts, if turned into law, would be the mostsignificant rewrite of international tax rules since 1962 and themost fundamental rethinking of taxation of financial products sincethe modern income tax began in 1913.

Camp, a Michigan Republican, hasn't unveiled the rest of hisplan, which he wants to advance through his committee this year. Hehas asked industry groups and others affected by the potentialchanges to offer comments.

“It's potentially a very positive step forward, and it'spotentially a very negative step forward depending on how thissection would fit in the larger tax reform mosaic of provisionsdealing with real estate,” said Jeff DeBoer, president and chiefexecutive officer at the Real Estate Roundtable. The Washingtongroup's board of directors includes executives of Dune Real EstatePartners LP and Hutensky Capital Partners.

Partnerships and other pass-through entities have become apopular way to organize businesses in the past 30 years because oftax-rate reductions for individuals, a double tax on corporateprofits and interaction with state legal structures.

Such pass-through entities accounted for 38 percent of businessreceipts in 2007, up from 14 percent in 1980, according to theCongressional Budget Office. Some large businesses are organized aspartnerships, including global accounting firms such as Ernst &Young LLP.

In 2010, 48 percent of partnerships were in the real estate,rental and leasing industries, according to the Internal RevenueService. Finance and insurance partnerships reported 48 percent ofnet income.

The draft proposal on pass-through entities presented twooptions, an incremental set of changes known as Option 1 that havebeen discussed for several years and the more significant changescalled Option 2.

Broader Shift

The idea behind the broader shift would be to consolidate therules governing S corporations and partnerships, both types ofpass-through entities.

The S corporation rules are relatively inflexible, compared withpartnership tax law. The law limits the number of shareholders,requires a single class of stock and restricts non-U.S.ownership.

The proposal would effectively remove some of those restrictionson S corporations and impose some new limits on partnerships.

Simplification would be welcome, though the proposal leans toofar toward pushing people into an S corporation structure thatgrowing businesses don't often use, said James Brown, a partner atWillkie, Farr & Gallagher LLP in New York.

“The proposal would make partnerships look too much like Scorps, with their disadvantages,” he said.

The changes could alter longstanding economic arrangements thatwere created to mesh with the current partnership rules. Thetransition to a new system, which isn't addressed in Camp's draft,will be important, particularly if the new rules affect existingpartnerships, DeBoer said.

“I think the transition rules are going to be absolutelyimpossible,” said Andrea Whiteway, chair of the partnership taxpractice at McDermott Will & Emery. “It will be absolutelycrazy, and I also think it will be crazy for S corps.”

Among the dozens of changes outlined in the draft, taxpractitioners are focusing on two areas in which the proposal wouldlimit partnerships' flexibility: special allocation anddistribution of appreciated property.

Under current tax law, partnerships can split tax benefits andincome among partners in myriad ways. For example, in many realestate partnerships, depreciation deductions can be given only tosome partners who want to use those breaks to offset otherincome.

Such special allocations reflect the different economiccircumstances of multiple properties inside a single partnershipand the varying contributions and levels of risk to individualpartners, said Karen Burke, a tax law professor at the Universityof San Diego.

'Economic Reason'

“While they can be abused, they do have an economic reason,” shesaid, suggesting that taxpayers could split apart partnerships anduse contracts to replicate what the tax changes might prevent. “Ifyou got rid of special allocations, people would have to recreatethem in other ways.”

The proposal would limit special allocations only to netordinary income and losses, net capital income and losses, and taxcredits.

On distributions, current rules say that it's not a taxableevent if a partnership distributes property that has appreciated invalue to one of the partners. Taxes are generally triggered onlyupon sale of the property.

The new rule, mimicking the S corporation structure, says thatthe distribution is a taxable event to the partnership, which wouldthen flow through to all of the partners.

The rules leave a number of issues unaddressed, including thetax treatment of private equity managers' carried interest, the lawgoverning real estate investment trusts and potential changes topublicly traded partnerships such as Enterprise Products PartnersLP.

Some of the changes being considered are so dramatic that theymight have made sense in the abstract, if the tax code were beingrewritten from scratch, Rubin said.

“It would be nice,” he said, “but it might be so painful gettingthere that it's just not worth the” effort.

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