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Time To Abandon The Aggregation Rules For Partnership Allocations?
Partnership income allocation complexities are on the rise across the board. Some argue the aggregation rules are broken but should they be fixed or scrapped? Is there a practical solution? Taxand US assesses the available options.
Over the past 15 years or so, partnerships have struggled with making allocations of income and loss, which governs a partner's distributive share of partnership items. As transactions have evolved and increased in sophistication, and as market conditions have changed with an upsurge in volatility, few partnerships are left with straightforward income allocations. Traditional private equity funds, hedge funds, real estate funds and publicly traded partnerships all face significant challenges.
Faced with a high volume of data and limited to tools such as Microsoft Excel, most partnerships and their accountants make as many reasonable assumptions as possible to simplify the problem down to a human scale. The most common "simplification" used by securities partnerships is to use an aggregation method, either "partial netting" or "full netting." These methods allow securities partnerships to allocate all tax items in respect to the partners' aggregated unrealised gains and losses. Simplification can lead to unintended, meaningful economic consequences. Some argue that partnership accounting cannot be simplified, and that the only way to address partnership complexity is with sophisticated tools and rigorous processes.
Given the sophisticated software tools and computing horsepower available today versus 10 or even 5 years ago, partnerships should address the issue head on. The problem of volume does not go away, but computers are now exceedingly good at dealing with it.
Lot Layering and Securities Aggregation
Lot layering requires partnerships to make allocations of realised gains and losses both in respect to the historical market values of individual assets and to the partners' varied interests in the unrealised gain and loss "layers" of those assets.
However, problems exist in the aggregation's inability to effectively reconcile economic gains and losses in individual assets with partners' simplified, portfolio-level unrealised gain and loss accounts. In volatile markets, unintended results can emerge. A common, frustrating occurrence is that partners suffering economic losses are allocated taxable gains from assets in which they enjoyed no economic appreciation.
Perhaps the most practical solution in all but the simplest partnerships is not to patch the aggregation rules, but rather to abandon them altogether in favour of sophisticated lot-layering approaches. Partnerships that take lot-layering approaches are assured that their partners' tax allocations have economic integrity. Recents developments in software have brought the most technically challenging, real-world partnership allocations problems within reach.
Advances in software have meant that new software applications can be customised to specific partnership agreements and can allow partnerships to take many tax modeling functions in-house. Clients who prefer to continue to outsource these functions to their tax provider should reap the same benefits of improved timeliness while also receiving more easily verifiable and understandable outputs, thus clarifying one of the remaining "black boxes" in tax.
In real-world applications, the simplifications given by aggregation methods ultimately cause more problems than they solve. An interesting irony is that in order to properly implement aggregation methods, a partnership must collect all the same data points necessary to perform lot layering. Yet, once aggregated, these economically meaningful asset-by-asset details are discarded. Partnerships that make this decision may well trade a near-term housekeeping problem for a potential long-term economic problem.
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