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Special Allocations
From the Nolo Internet Law 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
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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.
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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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