Special Allocations When partnerships were the most common form of unincorporated business entity, special allocations were rare. Even if a partnership did make a special allocation, some fairly short and simple additions to the partnership agreement were all that was needed to insure that it was effective for tax purposes. But things have changed. It's quite common for an LLC to make a special allocation, and the additional provisions that must go into an LLC's operating agreement to insure its effectiveness are anything but short and simple. A partnership or LLC is not a taxpaying entity. The income, loss, and other tax items of the entity must be allocated between its owners, be they partners or members, and reported on the owners' individual income tax returns. A special allocation occurs if any income, loss, or other tax item is allocated in a way that neither has substantial economic effect nor is in accordance with the owners' interests in the entity. A special allocation is ineffective for tax purposes under section 704(b) of the Internal Revenue Code, and the affected items can be reallocated by the IRS. A reallocation, which may well inconsistent with the owners' expectations and tax planning, can, however, be avoided if the special allocation is deemed to have substantial economic effect, or is deemed to be in accordance with owners' interests, under rules set forth in the income tax regulations. Whether a partnership has made a special allocation, and if so, whether it's effective for tax purposes, is ordinarily determined under the substantial economic effect test. An allocation has substantial economic effect if the economic consequences of the allocation follow its tax consequences. For example, an allocation of one-half of the losses of a general partnership to one of two partners has substantial economic effect because the losses will reduce the amount of partnership assets available for distribution to the partner when the partnership is dissolved and wound up. If losses are funded by the partnership's borrowing money or acquiring assets on credit, the partner will be personally liable for the partnership's purchase money obligation and will have to pay the obligation if the partnership's assets are inadequate. If the partner is a limited partner and has no personal liability for partnership obligations, an allocation of losses to the partner is deemed to have substantial economic effect under the income tax regulations so long as the partnership agreement requires capital accounts to be maintained and contains a qualified income offset. Such a provision prevents losses in excess of a limited partner's capital account from being allocated to the partner. Any excess losses are allocated to the general partner, who does not have limited liability and will, therefore, bear the economic consequences if losses that exceed the partners' capital accounts. It gets a bit more tricky with LLCs because all members have limited liability. An LLC can incur tax losses that are funded by loans to the LLC, or by credit advanced to the LLC, for which no member has personal liability. As a result, a special allocation made by an LLC almost always lacks substantial economic effect. Such an allocation has substantial economic effect only if the LLC's operating agreement requires capital accounts to be maintained and requires members to contribute additional capital to make up deficit balances in their capital accounts when their interests are liquidated. Such provisions are rarely included in LLC operating agreements because of the risk they can be enforced by the LLC's creditors, thus eliminating the members' limited liability protections. What this means is no allocation made by an LLC is effective for tax purposes unless it's either in accordance with the members' interests in the LLC within the meaning of section 704(b) of the Code or is deemed to be in accordance with the members' interests under the income tax regulations. An allocation is in accordance with the members' interests in an LLC if it's straight-up. A straight-up allocation occurs if each member of an LLC contributes capital and each member's percentage interest in income, losses, and interim distributions is the same as the percentage of the LLC's capital contributed by the member. Any deviation from a straight-up allocation results in a special allocation. For example, if one member of an LLC contributes capital, another contributes the services necessary to operate the LLC's business, and they agree to split income and losses equally, the allocation of income and losses is a special allocation because it's not proportionate to the members' capital interests. An equal division of income and losses also can result in a special allocation if both members contribute equal amounts of capital, but a disproportionately large share of the LLC's excess cash is later distributed to one member. If an LLC makes a special allocation, it will be deemed to be in accordance with the members' interests, and will be effective for tax purposes, only if the following three requirements set forth in section 1.704-2(e) of the income tax regulations are met:
The first two requirements are straightforward and are familiar because
such provisions were routinely included in limited partnership agreements.
It's the third requirement that creates problems because it necessitates
adding several pages of complex provisions to the operating agreement.
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