Making Special Allocations
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 does not correspond 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 -- for example, by allocating all business losses to the owner in the highest income tax bracket.
If the IRS rejects your special allocation, it will tax you and your co-owners as if you had divided profits and losses in proportion to your ownership interests, regardless of what your partnership agreement or operating agreement says.
Substantial Economic Effect
To be certain that a special allocation is legitimate, the IRS checks to see whether the allocation has what it calls "substantial economic effect." This jargon means that a special allocation must reflect the owners actual economic circumstances, not an effort to shift income around to reduce taxes.
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. Because there are legitimate financial reasons for the uneven split, the IRS should respect this special allocation.
Get Expert Help
Unfortunately, the IRS regulations covering substantial economic effect are complicated. 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 agreement or operating agreement to ensure that the IRS will accept your special allocation.