Residual-Risk Model for Classifying Business Arrangements

Tax law classifies business arrangements as one of three general structures: (1) disregarded arrangements, (2) tax partnerships, or (3) tax corporations. Since the enactment of the income tax in 1913, tax law has struggled unsuccessfully to develop an ideal model for classifying business arrangements. The current model’s sole virtue is its simplicity, derived from formalistic, elective attributes. Its greatest shortcoming may be that it disregards the reasons parties form business arrangements and the reasons they use economic items to reduce rent-seeking behavior and agency costs. That disregard often allows business participants to choose their tax classification and minimize their taxes, which erodes the tax base and shifts tax burdens to others but does not alter the parties’ economic relationships. This Article rejects the current model and presents a classification model based on the economic theory of the firm. Economic theory aids classification in three respects. First, it helps explain why parties form business arrangements. Second, it views business arrangements as nexuses of contracts composed of various parties. This view helps identify the economic aspects of business arrangements and the economic rights of business participants, irrespective of legal form. Third, economic theory demonstrates that residual risk (the right to the residual assets of a business) measures the economic interests parties have in business arrangements. In particular, residual risk helps distinguish between arrangements that can trace income from its source to the owner of the source, or from allocations to the beneficiaries of those allocations, and those that cannot. That knowledge clarifies the appropriate tax regime for all arrangements and leads to the residual-risk model for classifying business arrangements