Special Allocation of Profits - IRS Rules
Rules of the IRS for Special Allocation of Profits
Special Allocation of Profits IRS rules must be followed if you want to divide profits and losses in a way that's disproportionate to the owners' interests in the business(Special Allocation).
The one class of stock restrictions and the complex regulations governing S Corporation
status do not apply to LLCs, thereby allowing flexibility in planning distributions and special allocations
. The LLC
operating agreement can provide for special allocations of most items of income and deduction.
A business can divide profits and losses in a way that is not proportionate to the owners' percentage interests in the business, it is called a "special allocation." The IRS pays careful attention to special allocations to be sure business owners are not trying to hide potential tax dollars, by allocating all business losses to the owner in the highest income tax bracket.
As an example of a Special Allocation of Profits: Donna and Tony set up an LLC to operate their computer business. Donna puts up all the cash, while Tony signs a note to contribute his share in installments over the first four years of the business. Their operating agreement says that Donna and Tony each have a 50% ownership interest in the LLC, but it also says that Donna will be allocated 60% of the LLC's profits (and losses) for the first four years, and Tony will be allocated 40% of the LLC's profits during this initial period. After the first four 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 allow this special allocation since there are legitimate financial reasons for the uneven split(special allocation).
If the IRS does not 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.