How to Manage Special Allocations in Your Traditional LLC

Special allocations are often the trickiest things to deal with when it comes to a traditional LLC. However, by not understanding the intricacies of special allocations, you are missing out on one of the most valuable benefits of an LLC. An LLC provides flexibility. Special allocations are a prime example of this flexibility. Here’s how managing special allocations in your traditional LLC can benefit business partnerships and what to watch out for to avoid problems with the IRS.

What is a Special Allocation in a Traditional LLC?

A special allocation is made when the profits and losses from a business are split up in a manner that is different from the ownership percentage declared in the LLC operating or partnership agreement. For instance, Bill and John start a new bike repair business. John is able to put in more time and effort into the business. In fact, John is able to invest in the business full-time, while Bill can only invest in the business part-time since he is finishing up a two-year degree. In addition, John is investing more capital in initial startup cost, while Bill has agreed to invest his share of the business in smaller portions throughout two years. With the right wording, Bill and John can file LLC documents in a way that allows John a higher percentage of the profits and losses for the first two years of the business. Bill would be allocated a smaller share since he’s only invested part-time for the next few years.

Valid Special Allocations

In the above case, Bill and John are properly managing the special allocations in their traditional LLC. They are using the special allocations provisions of an LLC in a way that splits profits and losses according to actual economic circumstances. In IRS terms, their LLC’s special allocations are fulfilling “substantial economic effect” requirements.
 
In checking these requirements, the IRS does a two part analysis. The details of this analysis are complicated and are by no means as cut and dry as the above mentioned example. What is critical to understand is that the IRS takes great measures to find and reject any attempts to use special allocations to artificially reduce aggregate tax liability.

Pass IRS Special Allocation Requirements

This is why getting legal counsel is so critical when it comes to drafting LLC documents. We’ve helped several clients form LLCs with special allocations. We specify special allocations in a way that passes the IRS’s stringent two part analysis. What several so called “experts” won’t tell you is that if the IRS rejects your special allocations they will default to splitting up profits and losses according to the LLC’s ownership percentage split, which is typically 50/50. Don’t go through the trouble of drafting special allocations into your LLC operating agreement only to get it rejected. Get it done right the first time. Call us today at [GLOBAL VAR=phone-number] for a consultation.