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partnership activities or not, represent real economic losses. B many of them also reflect the use of tax preferences or tax ince tives that generate losses for taxpayers and create opportunities fo tax shelters. Above-the-line offsets represent the difference betwee all positive amounts of income and adjusted gross income, she

In its annual reports on high-income individual returns, the I ternal Revenue Service uses four income concepts ranging from th traditional and well-known concept of adjusted gross income to th concept of expanded income. Now, I am not going to go into th details of these various ways of analyzing returns except tonsa that for analyzing high-income returns, our concept of total pos tive income, or TPI, is a more useful measure of income than is ad justed gross income or any of the related concepts.

Like all measures, TPI is not perfect. There are no taxpayer data on the ideal measure of income economists frequently call econom ic vincome. In theory, economic income counts income from al sources, whether or not reported on the tax return, and accurately measures each form of income. Such an ideal measure of income would separate economic losses from losses claimed on returns. In practice, however, economic income is very difficult to measure and cannot be constructed using data only from tax returns, lik

For our purposes, we chose a high cutoff level, namely $250,000 of total positive income, for considering any return high income. We did that in part so that we could make sure to the extent that total positive income overstated economic income, that we were nevertheless talking about relatively high-income

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After we identified the category of taxpayers we would consider high income, that is, taxpayers with over $250,000 of total positive income, we then performed a computer examination of all individual tax returns, where total positive income was in excess of $250,000. In 1983 over 260,000 returns fell in this category, representing about one-quarter of 1 percent of all returns filed for 1983. A report that we submitted to the subcommittee on July 31 describes most of the results of that analysis. What I would like to do this morning is simply mention several of the findings and add a few points not reported in our July 31 transmittal to the a rather sidetantial growth, both gain partnerships on While much interest centers on high-income taxpayers who pay little tax, let me again emphasize that it is important to remember that most taxpayers filing the returns we examined paid a substantial share of their income in taxes in 1983. For example, nearly half owed tax equal to at least 20 percent of their total positive, income. Nearly one-quarter, 23.6 percent, for example, owed tax equal to at least 30 percent of their total positive income, and 56 percent lowed taxes equal to at least 40 percent of total positive: income. If you want to examine the data more specifically, table contains those data by income and tax-by total positive income and by tax rate or tax burden category. prominence in the last

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On the other hand, that table indicates that a significant minority of taxpayers owed very low taxes in 1983 relative to their total positive income. For example, 11 percent, or almost 30,000, high TPI taxpayers paid less than 5 percent of TPI in tax. Of those, over 3,000 had TPI in excess of $1 million. In addition, over 7,000 tax- r payers, or 2.9 percent of those filing returns with TPI over

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$250,000, owed zero tax. Of those, 931 Of those, 931 had TPI of at least $1 mildlion. For the high-TPI individuals taxpayers can also undertake tax-sheltered investments who paid little or no tax, I think e the question is: How did they do it? Table 2 seeks to show that the e above-the-line offsets to TPI were much more important than the below-the-line offsets, such as itemized deductions. And let me say's again it is for that reason, so that we could make that kind of anald the light ysis, that we used a TPI concept. payers ace those rates by investing in activiIn the aggregate, if you are looking at table 2, for high-income taxpayers owing less than 5 percent of tax, that is the second line on that table, itemized deductions offset only 18 percent of TPISO whereas if you look at the left-hand portion of that table, the socalled above-the-line offsets, you will see that for these highe income, low-tax people losses and capital gains deductions actually t exceeded TPI, offsetting 112 percent of TPI. nittee in July, Second, I Also, among the above-the-line offsets, what we called current business losses were more important than the combination of cap- I ital gains deductions and other kinds of losses, such as losses carrip ried over from previous years. Current business losses equal the partnership loss column, plus the column labeled "Other Current Business Losses." Current business losses for taxpayers w with a taxas liability under 5 percent of TPI offset 67 percent of TPL compared with 46 percent for capital gains deduction and loss category jargon Partnership losses dominated the category of business losses for rto these high-income, low-tax taxpayers. If you look at the data, youto will see that of the 67 percent, 36.2 percent of those losses were partnership losses. It is this kind of data that suggests to us that it is appropriate to examine what it is about those partnership losses dus that contribute to the use of partnerships by high-income taxpay ersist the items that receive most attention are the so-called belowHigh-income taxpayers as a group, including those paying signifi cant taxes, also make substantial use of above-the-line offsets, but less than the high-income taxpayers with low total tax liability. You can determine that from looking at line one on table 2. Withinre the category of current business losses, partnership losses again, dominated, respectively, almost 11 percent of TPI or one-quarter of all above-the-line offsets for all high-income taxpayers. Thus, part nership losses clearly are a major, though not the only, source of reduction to taxable income and, therefore, in tax liabilities paid by high-income items of deduction or credit that are High-income taxpayers also report a disproportionate share of the partnership losses that appear on individual tax returns. If you turn to table 3, you will see that approximately 166,000 returns, or 64 percent of all high-income taxpayers, registered some partnerspt ship loss in 1983. Only 2 percent of all taxpayers reported partnernd ship losses. I think that statistic clearly indicates the major rolene partnership losses play with respect to the so-called high-incomeve category The aggregate amount of losses reported on the individual returns totaled $17.6 billion, or, 52 percent of the total of $32.2 billion in partnership losses reported on all high-income tax returns in 1983. income before both above the line and below-the-line Just for comparison purposes, these high-income taxpayers generated less than 10 total positive income in 1983.nt Whereas partnership on all individual returns ex

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ceeded partnership losses by $900 million in 1983, among highincome returns, the losses exceeded gains by $6.5 billion.

Again, I want to emphasize, however, that the TPI measure does not distinguish between economic losses and losses that appear only for tax purposes. Some portion of these partnership losses, thus, represent real economic losses that properly reduced the taxable income shown on the returns examined. From our data, the real economic losses that result from bad luck, misjudgments, or other business errors cannot be distinguished from losses advertised by tax-shelter promoters. We know total positive income includes some real losses, but we also know that other frequently used measures, adjusted gross income, exclude all tax shelter losses.

Available information does permit us, however, to help understand better the source of these losses, and that is the focus that I want to turn to in the remaining portion of my testimony. Since our analysis that we transmitted to you, Mr. Chairman, in July has identified partnerships as the main source of business losses for high-income taxpayers and since there is much interest in partnership as a common vehicle for tax shelters, let us turn to a more specific focus on the partnership sector, and I would like to begin by focusing on some historical data on partnerships.

Historically, the partnership sector has been the source of substantial taxable income for individuals and for taxpayers as a whole. If you will turn to table 4, you will see that if you look at the partnership data in column 1, for example, in the mid to late 1960's-the bottom of that table-partnerships generated net income of roughly $10 billion a year. You can see that number was $9.7 billion in 1965 and rose to a high of $11.4 billion in 1968, but hovered in the $10 billion range throughout the mid to late 1960's. During the 1970's, the gains and losses generated by partnerships grew substantially, although the net income for the sector as a whole and the net amounts reported on individual returns did not show similar growth until the latter part of the decade. But if you look at the 1970's, and I would suggest you look at the second and third columns for gain partnerships and for loss partnerships, you will see a rather substantial growth in both gain partnerships and loss partnerships.

The pattern of fairly stable or generally rising net income from partnerships changed abruptly in 1980. Between 1979 and 1980, net income for the sector dropped from $15.2 to $8.2 billion, and net losses, losses from loss partnerships, jumped from $24.8 to $36.8 billion. In 1981, partnerships in the aggregate reported a net loss for the first time in 25 years that annual statistics on partnership returns have been available. The net losses in the partnership sector have continued through 1983, most recent year for which statistics are available, with 1983 showing the greatest net loss of the 3 years. Losses have assumed a greater prominence in the last 3 years for which statistics are available than in any time during the three decades of statistics on partnerships. In 1981 and 1982, individual taxpayers overall reported net losses from partnerships on their individual income tax returns.

Generally over the past two decades, growth within the partnership sector has been concentrated in certain industries and types of

partnerships. Our July 31 report to the subcommittee documented that. If you look at table 5, we have tried to identify broad industry categories. And what you will see in table 5 is that between 1965 and 1983-I am incidentally referring to the second category, the one that is headed "Number of Partnerships With and Without Net Income"-the number of partnerships in both real estate and finance more than tripled. Oil and gas partnerships more than quadrupled. Meanwhile, the total number of partnerships in other industries increased by only 15 percent.

Continuing to look at table 5, between 1965 and 1983, the number of partnerships reporting losses more than tripled, from 229,000 to 750,000 partnerships. Particularly rapid growth in the number of partnerships with losses appeared in the oil and gas and real estate industries. If you look at the third category, "Percentage of Partnerships Without Net Income," you can see by percentages the details in all of those industries and the growth in the industries that I mentioned to you.

Although limited partnerships represented only 1 in 12 of all partnerships in 1977, they accounted for one-third of the increase in the number of partnerships between 1977 and 1983. Only onequarter of all partners in 1977 belonged to limited partnerships, but 88 percent of the increase in partners over the next 6 years was attributable to limited partners. General partnerships experienced little growth during the same period.

Now let's focus on the third type of data we analyzed, that is, partnership losses during the period 1981 through 1983. Partnerships do not pay taxes themselves. Rather, a partnership is an entity that passes through income and expenses to its partners. Generally these items are taxed as if received by the partners, although special rules and limitations apply to some of these items. Consequently, what a partnership reports as partnership income is not what most people would generally consider income from a partnership.

Therefore, we made some adjustments to the measure of net income that partnerships report on form 1065-1065 is the number of the form that partnerships file with the Internal Revenue Service on which they show what are referred to as distributive share income and loss. We refer to the measure of income that we begin with, that is, what comes from the partnership return, as "1065 net income."

If you turn to table 6, and if you begin by looking at the fifth line on that table, you will see form 1065 income or loss. That is the beginning point in our analysis, and that is the number that we got out of our computer analysis of partnership returns filed during this 3-year period.

Now, as I indicated to you, we wanted to arrive at a concept that would reflect the contribution the partnership activities make to taxable income or losses reported by the separate taxpayers, by the partners, that is. Some of the adjustments we made involved items of income or expense which are subject to special treatment at the partnership level, such as investment interest expense or long-term capital gains. A few of the adjustments required estimates of items not fully reported on any of the partnership tax forms. Most of the mineral exploration costs fall into that category. Income after


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these adjustments is called contribution to partner's taxable income. If you go down to the bottom of that table, you will see a line, the second one from the bottom, called "Contribution to Partners' Taxable Income."


Between the form 1065 income or loss at the top of the table and the bottom, the contribution to partners' taxable income, are the adjustments that we made to get to that contribution to partners' taxable income. A more detailed description of those items is in the remation apa attachment to the testimony. detailed



ble 8

Chairman PICKLE. Mr. Pearlman, I want you to continue with your testimony, and Mr. Anthony is here, too. Continue. But let me dask you, when the partnership fills out its 1065 that is filed with the IRS by the partnership? ough e value of the underlying Mr. PEARLMAN. That is correct..... are. deed, like Chairman PICKLE. I assume they send a copy of that 1065 or thschedule K or some other form to the individual partner of the limwited partnership. What procedure is followed from that point? Do you keep a copy of it you keep copies of the 1065, the copy that you send to the individual partner? How do you know that partner athen makes his return, and what record do you have of that?aine


Mr. PEARLMAN. Let me try to describe both what happens at the Internal Revenue level and what happens at the partnership and partner level. You are correct, the form 1065 is filed with the Inbeternal Revenue Service. It has, among its attachments, what is releferred to as a schedule K, and then it has, in addition to that, some toadditional attachments which are referred to as schedule K-1. There is a schedule K-1 prepared for each partner. So attached to ththe 1065 is a schedule K that simply totals the various 1065's for viall of the partners, as well as a copy of each schedule K-1 which is prepared for each partner. All of that goes to the Internal Revenue Service as part of the filing by the partnership.

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In addition, then, the partnership sends a copy of the schedule K-1 to each partner. The schedule K-1 is utilized by that partner in preparing the partner's individual tax return.

Not everything that the individual partner needs to know as a result of partnership activity is contained on the schedule K-1. In those instances, the partnership is required to provide additional information to the individual partners. And the Internal Revenue Service gets that information too.


But when we do our computer analysis of partnership returns, we don't pick up all of that information that is not on the returns, and that is one of the reasons that we had to do some adjusting from the actual partnership return data that I referred to a moment earlier in my testimony.

I want to point out the overall effect of those adjustments we made on net income was relatively small. For example, in 1983, socalled 1065 net income, again looking at that top number, showed for all partnerships a loss of $2.6 billion, whereas we estimate the contribution to partners' taxable income after investment tax credit as a loss of $0.9 billion. The coincidental closeness of $2.6 and $0.9 billion hides an increase in the gain reported by gain partnerships and a nearly offsetting by losses reported by loss partnerships.

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