The simplest business arrangements (whether it's a partnership or an LLC) typically involve a split of the profits and debts that closely tracks to each partner's contribution to the business. So in a two-person partnership where each partner contributes the same amount of time and energy into daily operations, the partners will likely split profits 50/50.
However, if one of the partners contributed 75 percent of the start-up capital, he or she may not want to wait too long for a return on that extra investment. This is where special allocations come in. The following is a brief explanation of how special allocations adjust for such scenarios.
What is a Special Allocation?
Creating a special allocation for a business means dividing up profits and losses among members in a way that doesn't correspond to the members' actual ownership interests. There are many legitimate reasons for businesses to do this, but the Internal Revenue Service (IRS) also knows that businesses can use a special allocation in order to inappropriately lessen the tax liabilities of its members. For that reason, the IRS will closely examine a business' special allocation to make sure that the business has a valid justification for it.
If the IRS denies a special allocation, it will ignore whatever the partnership or operating agreement for the business says and levy taxes on the members of business according to the proportion of the members' ownership interest.
The IRS looks for a "substantial economic effect" in order to determine whether a special allocation is above board. A special allocation with a substantial economic effect reflects the actual economic situations of its members rather than an artificial attempt to shift tax liability in an advantageous way.
Fred and Ginger LLC: An Example of a Special Allocation
An example will probably help clarify the notion of a substantial economic effect:
Fred and Ginger want to set up a dance studio, so they form an LLC to handle the business operations. Fred has enough cash on hand to fund the start-up costs, but Ginger needs to pay her share in installments. She signs a promissory note pledging to pay for her portion of the business over the next two years.
The LLC's operating agreement states that, while Fred and Ginger both have a 50 percent ownership share of the business, Fred will receive 75 percent of the profits and losses during the two years when Ginger is paying off her share of the business. After Ginger has put up her share of the start-up costs, the operating agreement states that the two owners will split the profits and losses equally.
Because this special allocation reflects the fact that Fred has more money invested in the business for the first two years, the IRS will accept that there is a substantial economic effect and approve the allocation.
Unfortunately, not all situations where businesses create a special allocation are as cut-and-dry as the example above. The rules regarding substantial economic effect are also very complicated, so it's in a business' best interest to consult a tax professional such as an accountant or a tax lawyer and get their help in drafting partnership or operating agreement language so the IRS will approve the special allocation.
Get Legal Help Setting Up a Special Allocation
Whether you're just starting a new business entity or need help with a special allocation or other business tax issues, you may benefit from professional legal assistance. Consider meeting with a business and commercial law attorney near you.