From the Nolo eCommerce Center
You must carefully follow IRS rules if you want to divide profits and losses in a way that’s disproportionate to the owners’ interests in the business.

If a business splits up profits and losses in a way that is not proportionate to the owners’ percentage interests in the business, it’s called a “special allocation.” The IRS pays careful attention to special allocations to be sure business owners aren’t playing hide and seek with potential tax dollars – say, by allocating all business losses to the owner in the highest income tax bracket.

If the IRS doesn’t accept a special allocation that you make, it will tax you and your co-owners as if your distributive shares are in proportion to your ownership interests, regardless of what your partnership or operating agreement says.

To be certain that a special allocation is legitimate, the IRS checks to see if it has what it calls “substantial economic effect.” This jargon means that a special allocation must be based on real economic factors of the owners’ circumstances – not used to simply shift income around to reduce an owner’s income taxes.

Example

John and Anna set up an LLC to operate their consulting business. John puts up all the cash, while Anna signs a promissory note to contribute her share in installments over the first two years of the business. Their operating agreement says that John and Anna each have a 50% ownership interest in the LLC, but it also says that John will be allocated 75% of the LLC’s profits (and losses) for the first two years, and Anna will be allocated 25% of the LLC’s profits (and losses) during this initial period. After the first two years, the agreement says that both members will split LLC allocations of profits and losses 50-50 – that is, in proportion to their ownership interests. The IRS should respect this special allocation since there are legitimate financial reasons for the uneven split.

Unfortunately, the IRS regulations covering substantial economic effect go on for about 80 pages (Sections 1.704.1 through 1.704.3 of the Income Tax Regulations), so if you want to set up a special allocation, you’ll need expert help to make sure that your allocation will pass muster with the IRS. A good accountant or tax lawyer – one who provides advice on this area of tax law as a regular part of her practice – can draft special language for your partnership or operating agreement to ensure that the IRS will accept your special allocation.

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