Why should every LLC Operating Agreement include special “tax allocation” provisions?
The LLC Operating Agreement governs how profits, losses, and other tax allocations are made to the members. Therefore, absent some overriding rule, the members are generally permitted to agree among themselves as to how the LLC’s income and losses will be allocated.
The special “tax allocation” provisions sets forth the manner in which allocations of LLC items of net profits, income, gain, net losses, and deduction should be made to the members in certain circumstances.
A LLC is subject to complex federal tax rules regarding the allocation of profits and losses. Allocations must have “substantial economic effect” or they will be reallocated in accordance with the members’ “interests” in the LLC.
Internal Revenue Code Section 704(b) is the primary provision that governs allocations, although it is not the only one. For example, the allocation of gain or loss inherent in contributed property is governed by Internal Revenue Code Section 704(c).
The special “tax allocation” provisions contained in a well drafted LLC Operating Agreement, such as the Qualified Income Offset, the Company Minimum Gain Chargeback, and the Internal Revenue Code Section 704(c) allocation provision are generally included in the LLC Operating Agreement to help govern how allocations of items of income, gains, and losses of the LLC should be allocated. It is important that these provisions are included in the LLC Operating Agreement in order secure that the allocations made by the LLC are made correctly and respected for tax purposes. It also offers the accountant preparing the tax return for the LLC a framework for determining how LLC allocations should be made.
Substantial Economic Effect
An allocation to a member of a distributive share of profits or losses of the LLC under the terms of the LLC operating agreement will be respected for tax purposes if it has “substantial economic effect” or if it is in accordance with the members’ “interests” in the LLC.
An allocation of LLC profits or losses among the members has “substantial economic effect” if it passes a two-part test applied as of the end of the LLC year to which the allocation relates. First, the allocation must have economic effect. This means that it must be consistent with the underlying economic arrangement of the members. Second, the economic effect of the allocation must be “substantial”. The economic effect of an allocation is “substantial” if there's a reasonable possibility that it will affect substantially the dollar amounts to be received by the members from the LLC, independent of the tax consequences.
For example, Joe and Ann each contributed $500 to ABC LLC which used the $1,000 to buy a building. Joe and Ann capital account was balance was $500. The members agreed to divide all items of income, loss, and deduction equally except depreciation which was allocated entirely to Joe. At the end of year 1, the LLC had $200 of depreciation which was all allocated to Joe. A year later, the IRS questioned the allocation and a court later held that the $200 of depreciation allocated to Joe did not have “substantial economic effect”. The court determined that since the parties agreed to an equal division of LLC property, if the LLC sold the property at the end of year 1, the $800 would be allocated equally to the members ($400 each) even though Joe’s capital account balance would be $300 ($500 capital balance minus $200 of depreciation allocated to Joe).
The Qualified Income Offset Provision
This provision explains that if a member unexpectedly receives an adjustment, allocation, or distribution from the LLC causing such member to have a negative capital account balance, such member will have allocated, as quickly as possible, LLC income and gain items sufficient to erase any capital account deficit that was created by the unexpected adjustment, allocation or distribution. Those income and gain items must consist of a pro rata amount of each item of the LLC’s income for the year, including gross income and gain. A “qualified income offset” provision is significant because if the LLC agreement contains a “qualified income offset provision” a member may be allocated losses without being required to restore a capital account deficit.
Allocation of Member Nonrecourse Deductions Provision
This provision explains that member nonrecourse deductions (deductions with respect to nonrecourse debt (i.e. member loan to the LLC)) will be allocated to the member who bears the economic risk of loss with respect to the deductions. If more than one member bears the economic risk of loss, deductions are allocated according to the ratio in which the members share the risk.
Allocation of Nonrecourse Deductions Provision
Company nonrecourse deductions (deductions attributable to debt which the members are not liable for) shall be allocated to the members based on their percentage interests in the LLC. In other words, when property is transferred subject to nonrecourse liability which exceeds the property’s basis, the members will be forced to include in income an amount equal to the difference. This inclusion offsets the nonrecourse deductions previously allocated to the members.
Company Minimum Gain Chargeback Provision
This provision explains that if there is a net decrease in “company minimum gain”, each member shall be allocated such member’s share of the “company minimum gain”. “Company minimum gain” is created when the company borrows money on a nonrecourse basis and the LLC claims deductions (typically depreciation) that decrease the company’s basis in the property below the balance of the nonrecourse debt securing the property.
Member Minimum Gain Chargeback Provision
This provision sets forth that if there is a net decrease in “member minimum gain” that net decrease will be allocated to the member based on the member share of the net decrease. “Member minimum gain” is created when a member loans money to the LLC or guarantees a LLC loan, thus, bearing the economic risk of loss with respect to the amount of the loan, and the LLC claims deductions (typically depreciation) that decreases the company’s basis in the property below the balance of the member nonrecourse debt securing the property.
Section 704(c) Allocation Provision
Section 704(c) dictates that income, gain, loss, or deduction attributable to property contributed to a LLC by a member must be allocated to the contributing member solely for tax purposes. The purpose of Section 704(c) is to prevent the shifting of tax consequences among LLC members with respect to pre-contribution gain or loss. A LLC must allocate income, gain, loss and deduction for contributed property so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution.
This provision explains that any income, gain, loss, or deduction attributable to property contributed to the LLC by a member shall be allocated, solely for tax purposes, to the members in accordance with the principles of Section 704(c). Management has the ability to determine which 704(c) allocation method will be used (i.e., traditional method, traditional method with curative allocations, or remedial allocation method) as long as the method used reflects the intention of the agreement.
