When you have a business partnership (or an LLC that is treated as a partnership for federal income tax purposes), profits and losses typically need to be divided or allocated to the partners.
This is typically done in a way that corresponds with each of the partners’ percentages of business ownership.
If you want to divide or distribute profits in a way that does not correspond with the partners’ percentage interests in your business, then you need to look into something known as a special allocation.
You need to be very careful with partnership special allocations of profits and losses for purposes of taxation and the Internal Revenue Service (IRS).
Since special allocations can be used in some cases to avoid taxation, the IRS pays special attention to these situations.
If the IRS does not believe that the special allocation is legitimate, it can tax all of the partners according to their percentage interests in the business even if there is another agreement—such as your partnership agreement—that says otherwise.
To understand how special allocations work, it is essential to learn more about why they occur and how the IRS determines their legitimacy.
Why Businesses Arrange for a Special Allocation
When you form a partnership, you will also create a partnership agreement (an operating agreement for an LLC). In a partnership, profits and losses typically get distributed to owners of the business based on their percentage interests in the partnership.
For example, imagine a business that has a partnership structure with four partners: Partner A, Partner B, Partner C, and Partner D. Each partner owns 25 percent of the business, or has a 25 percent interest in the partnership.
The U.S. Small Business Administration (SBA) makes clear that profits are passed through to the owners’ personal tax returns. In terms of typical taxation for a partnership, each partner will have profits and losses allocated according to his or her percentage interest in the business and then will pay taxes on those profits and losses.
In the above hypothetical example, each of the partners would be allocated profits and losses that correspond to 25 percent of the business’s profits and losses, and then would be taxed on that amount.
However, there are some situations in which there may be a need for a special allocation. For example, if Partner A provided all of the startup income for the business, the partnership agreement (or an operating agreement in an LLC) might stipulate that Partner A will be allocated 75 percent of the business profits and losses the first year.
This accounts for her initial investment, and the remaining three partners will be allocated equal percentages of the remaining 25 percent of the business profits and losses.
IRS Issues with Special Allocations and the “Substantial Economic Effect” Test
The above hypothetical scenario is a legitimate reason for a special allocation, but the IRS often looks closely at special allocations because they can be a way for the partners to avoid paying taxes. For example, a special allocation could allocate a larger percentage of profits and losses to a partner who can pay fewer taxes due to his or her tax bracket.
Accordingly, the IRS looks at a special allocation to decide whether it has a “substantial economic effect.” If it does, the IRS allows the special allocation. The term “substantial economic effect” is a complicated one to understand. In short the special allocation needs to be in line with the economic circumstances of the partners.
Given the complicated nature of special allocations, you should always work with an experienced business lawyer to ensure that the special allocation will pass muster with the IRS.
Contact a Business Law Attorney in Florida
If you are part of a partnership and you have questions about special allocations, it is extremely important to speak with a Florida business law attorney about how these work. You do not want to allocate profits and losses in such a way that violate rules of taxation.
An experienced Florida business lawyer at our firm can speak with you today about your business needs and can begin providing your partnership with information about tax law and special allocations. Contact BrewerLong today for more information about how we can help your business.