Question

Respond to the following in a minimum of 175 words:

• What is the difference between the aggregate and entity theory of partnership taxation?
• Provide two examples of how partnership tax rules reflect the aggregate theory and two examples of how they reflect the entity theory.

Answer 1

History:

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 theoriesare 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.

Aggregate 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 makesit 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.

The aggregate theory of partnership is grounded in the definition of a partnership, ‘An association of two or more persons to carry on as co-owners of a business for profit’. The definition doesn’t say a separate entity, it states ‘… two or more persons …’. This approach impacts several principles of business including:

1) Rights to sue and be sued
2) Ownership rights
3) Interaction with third parties
4) Separation of the partners from the entity or whole

To help clarify the aggregate theory this section will address both ownership rights and interaction with third parties.

Entity theory:

The entity theory advocated by some states grants more credence to the whole than to the individual partners. One of the primary differences is with the separation of partners as individuals from the partnership. Under the entity theory responsibility for acts of partners tends to mimic agency law whereby the partnership is held accountable. The aggregate theory leans toward holding the individual partner accountable first before looking to the partnership for responsibility. This is important when drafting the “Acts Discreditable” article for the partnership agreement. Under the entity theory, any act discreditable requires reimbursement to the partnership for the financial cost. In aggregate based states, the perpetrator of the act assumes all financial responsibility for his actions.

Another key difference relates to ownership of specific property. The entity theory advocates ownership by the whole partnership whereas the aggregate theory tends towards individuals owning the property as tenants in partnership.

Summary – Aggregate and Entity Theories of Partnership

There exists two distinct theories of partnership as promulgated by the Uniform Partnership Act. Each state in the union will align their interpretation with either the aggregate (a partnership is a business of individual partners) or the entity (a partnership as a whole) theory. At a minimum, all states allow the specific partnership property to be titled to the partnership. However, the legal matters begin to diverge from this point depending on the respective accepted theory of existence. The end result is a quasi existence of partnership in each state. Both owners and legal professionals must understand their respective state’s interpretation to draft an appropriate partnership agreement.