Taking Advantage of Partnership Special Allocations
One of the advantages of operating a business as a partnership is the right to make special allocations of tax items among the partners. You have the same opportunity if you run your business as an LLC that’s treated as a partnership for federal tax purposes.
In this article, the term partnership will cover an LLC that’s treated as a partnership for tax purposes, and the term partner will cover an LLC member who is treated as a partner for tax purposes. Onward.
What Is a Special Tax Allocation?
A special tax allocation is an allocation of an item of partnership loss, deduction, income, or gain among the partners that’s disproportionate to the partners’ overall ownership interests.
The best measure of a partner’s overall ownership interest is the partner’s stated interest in partnership distributions and capital, as stated in the partnership agreement.
Example. An allocation of 80 percent of a partnership’s 2020 tax loss to Partner A, whose stated ownership is only 25 percent, is a special allocation of the tax loss.
Pass-Through Taxation
After the partnership allocates its tax items among the partners, the allocated amounts (including any special allocations) are passed through to the partners on their annual Schedules K-1 received from the partnership.
Each partner then takes the passed-through amounts reported on Schedule K-1 into account on the partner’s federal income tax return (Form 1040 for an individual partner).
The partnership itself does not pay federal income tax. You and the other partners pay tax at the owner level. This is called pass-through taxation, because the tax consequences of the partnership’s activities are passed through to you and the other partners.
Key point. If you run your business as an S corporation, the pass-through taxation principle applies there too. But you’re not allowed to make special allocations of S corporation tax items among the shareholders.
Instead, you must allocate all tax items strictly in proportion to stock ownership. So, the ability to make special tax allocations is often a key selling point of partnership status as opposed to S corporation status.
How Special Tax Allocations Work
A partnership special tax allocation arrangement might work like this.
During the first few years of operation, when tax losses are expected, a disproportionately large percentage of the losses are specially allocated to the partners who need tax losses the most.
These may be the partners who supplied most of the initial capital, and they may be passive limited partners who are really just investors.
The other partners may be the ones who actually run the partnership’s business or investment activities, and they may be the general partners of a limited partnership. These partners are allocated a disproportionately small amount of the losses during the start-up phase when losses are expected.
In later years, the partnership is expected to generate positive taxable income and/or gains. Otherwise, the partnership was a bad idea to begin with.
The partnership will allocate a disproportionately large percentage of these later-year income and gain items to the partners who received earlier special allocations of losses. After these later-year special allocations of income and gain have offset the earlier special allocations of losses, all partnership tax items are allocated in proportion to the partners’ stated ownership percentages.
The special allocation phase of the partnership is over, and life goes on.
On a cradle-to-grave basis, you expect that all partners will receive cumulative allocations of taxable losses, deductions, income, and gain in proportion to their stated ownership percentages. So, the special allocations simply affect the timing of when you and the other partners recognize losses, deductions, income, and gain.
While the preceding description of a special allocation arrangement is often accurate, you can also have special allocations of specific tax items, such as depreciation, rather than special allocations of overall partnership losses.
Federal Income Tax Rules Governing Partnership Tax Allocations
Over the years, the IRS has issued a bunch of complicated regulations that are intended to prevent “abusive” partnership tax allocations.
Some Technical Rules
The anti-abuse regulations are known as the substantial economic effect rules.
The substantial economic effect rules are a safe-harbor method for allocating partnership tax items for federal income tax purposes. If you can manage to follow the rules, the IRS cannot challenge your tax allocations.
But the substantial economic effect rules are so complex that full compliance is difficult, if not impossible— even for partnerships that have a fervent desire to comply so as to eliminate any doubt that their tax allocations are valid.
Compliance with the substantial economic effect rules can also be expensive, due to additional professional fees.
In the real world, there may be few partnerships that are in full compliance with the substantial economic effect rules. Anything less than full compliance means the partnership must rely on the so-called partners’ interests in the partnership (PIP) principle to validate its tax allocations.
In Reg. Section 1.704-1(b)(3)(ii), the IRS states that the following four factors are important in determining PIP:
the partners’ relative contributions to the partnership,
the partners’ interests in economic profits and losses,
the partners’ interests in cash flow and non-liquidating distributions, and
the rights of the partners to receive liquidating distributions.
All that said, the fundamental objectives of the substantial economic effect rules and the PIP principle are the same: to attempt to ensure that partnership tax allocations reflect the actual economic arrangement between the partners.
If you cut through all the complexity of the rules and regulations, they really stand for the simple proposition that partners cannot be allocated taxable losses unless they are also allocated the related economic losses.
By the same token, partners cannot be allocated taxable income and gain unless they are also allocated the related economic income and gain.
The most important thing to understand is that you generally must maintain partner capital accounts that reflect how losses, deductions, income, and gain are allocated to the partners.
Capital accounts measure each partner’s equity in the partnership under whatever basis of accounting the partnership uses for that purpose. Upon liquidation of the partnership, the partnership must distribute money or property to partners (or collect from partners) according to their respective positive or negative capital account balances.
Under this fundamental principle, a special allocation of taxable losses, deductions, income, or gain generally must result in a potential cost or benefit to the partner in terms of what the partner would receive if the partnership were liquidated.
Question. Is it permissible for partners who receive special allocations of tax losses in the early years of the partnership to receive later “makeup” special allocations of taxable income or gain?
Answer. Yes.
If the partnership turns out to be unsuccessful, partners who receive special allocations of losses in the early years will never realize the hoped-for “makeup” special allocations of income or gain.
They will pay for their special loss allocations by receiving less money when the partnership is wound up and all partner capital accounts are liquidated. Partners may be willing to accept this risk in return for the tax-saving advantage delivered by special allocations of losses in the early years of the deal.
Some Examples
Please go through the following examples to gain a better understanding of the special tax allocation issue and how special allocations may or may not pass muster under the federal income tax rules.
Example 1: Permissible Special Allocation Scheme.
The Advanced Distance Learning Concepts Limited Partnership is formed with two general partners, Bob and Carol, and 10 limited partners.
Bob and Carol contribute $10,101 each and supply the technical expertise.
The limited partners supply $2 million in start-up capital.
Under the partnership agreement, the partnership will maintain capital accounts calculated using tax-basis accounting.
Upon liquidation of the partnership, partners with positive capital account balances will be paid according to those positive balances.
Any partners with negative capital account balances upon liquidation must pay the partnership to restore their balances to zero.
During the life of the partnership, each partner’s capital account will be reduced by allocated losses and deductions taken into account under the federal income tax rules and regulations.
Each partner’s capital account will be increased by allocated income and gains taken into account under the federal income tax rules and regulations.
Taxable losses are expected for the first three years of operations. After that, the partnership is projected to generate increasing amounts of positive taxable income.
Under the partnership agreement, the limited partners will be allocated 99 percent of cumulative taxable losses up to $2 million.
Cumulative losses in excess of $2 million will be allocated 100 percent to the general partners (Bob and Carol).
Taxable income will be allocated 99 percent to the limited partners until the cumulative losses allocated to them have been offset and they have received a cumulative 8 percent annual return on invested capital. Beyond that point, taxable income will be allocated 50/50 between the limited and general partners.
Observation. As you can see, the economic arrangement between the partners is a 50/50 deal after the limited partners have recovered their invested capital plus an 8 percent annual return.
This tax allocation scheme passes muster under the federal income tax rules and regulations. Here’s why.
If $2 million in taxable losses are allocated to the limited partners, and the partnership is liquidated for no value because it turned out to be a really bad idea, the limited partners will receive nothing. Their capital accounts will be zeroed out by the tax losses allocated to them. The limited partners will have paid for their $2 million of deductions by losing their entire investment.
Alternatively, if the partnership is successful, the limited partners will receive current and liquidating distributions equal to their $2 million investment, plus an 8 percent return, plus the cumulative amount of additional taxable income and gain allocated to them.
That’s the idea behind the federal income tax rules and regulations.
Simply put, the rules are intended to enforce the principle that allocations of taxable losses, deductions, income, and gain must correspond to allocations of the real economic losses, expenses, income, and gain realized by the partnership. The tax allocation scheme in this example is consistent with that principle, even though it includes special allocations.
Example 2: Improper Special Allocation Scheme.
Same basic facts as Example 1.
But in this example, the partnership agreement states that the limited partners will be allocated 99 percent of all taxable losses and deductions throughout the life of the partnership.
The general partners will be allocated 99 percent of all taxable income and gain throughout the life of the partnership. Bob and Carol have large net operating losses from other ventures, so they have no problem with being allocated almost all of the partnership’s taxable income and gain.
The partnership agreement further states that cash distributions during the life of the partnership and upon liquidation will go 100 percent to the limited partners until they have recovered their $2 million investment plus a cumulative 8 percent annual return. Any additional distributions will be allocated 50/50 between the limited and general partners.
As in Example 1, the actual economic arrangement between the partners is a 50/50 deal after the limited partners have recovered their capital plus an 8 percent annual return.
You will not be surprised to learn that the tax allocation scheme in this example is not permitted under the tax rules. Here’s why.
The limited partners will be allocated taxable losses and deductions that have no effect on the distributions they are entitled to receive from the partnership. By the same token, the general partners will be allocated taxable income and gain that will have no effect on the distributions they are entitled to receive.
For instance, say the partnership turns out to very successful and is ultimately liquidated for a cool $20 million. Bob and Carol will receive 50 percent of whatever is left after the limited partners have recovered their $2 million investment plus their 8 percent return.
But Bob and Carol have been allocated 99 percent of the taxable income and gain generated by the deal. This mismatch between the allocation of the economic gain (50/50) and the allocation of taxable income (99/1) is exactly the sort of thing the tax rules are intended to prevent.
Various Types of Partnership Ventures Can Involve Special Tax Allocations
Please understand that you can have permissible special tax allocation schemes for various types of partnership business and investment activities.
For instance, you might set up a real estate investment partnership deal that makes special allocations of tax depreciation deductions to certain partners.
As a general rule, those special allocations will be permissible under the federal income tax rules as long as
they reduce the recipient partners’ capital accounts, and
partner capital account balances are used to determine which partners receive money or property from the partnership upon liquidation and which partners (if any) must contribute to the partnership to restore negative capital account balances upon liquidation.
Beyond the Special Tax Allocation Basics
You can run into trouble with the IRS if you try to make special allocations of tax items that would be treated differently at the partner level—depending on the partners’ specific tax situations. For instance, a partnership’s long-term capital gains, dividends, and cancellation of debt income may all be treated differently at the partner level.
Example 3: Shifting Allocation.
You want to specially allocate all long-term capital gains and dividends to individual partners who will benefit from the lower federal income tax rates on those items. Corporations don’t benefit from lower tax rates on long-term gains and dividends.
So, you would specially allocate more of the partnership’s ordinary income to your corporate partners to offset the special allocations of long-term gains and dividends to your individual partners.
Sorry, but this tax allocation scheme involves a so-called shifting allocation that is generally disallowed by IRS regulations.
Example 4: Transitory Allocation.
You have a two-person 50/50 investment partnership. You want to allocate all $100,000 of the partnership’s current-year capital gain income to Barb, who has a large capital loss carryover into the current year. You would allocate $100,000 more of the partnership’s ordinary income to the other partner, Carlos.
So, each partner would be allocated the same overall positive amount, but Barb can shelter the capital gain income allocated to her with her capital loss carryover.
Next year, you would make compensating allocations of an extra $100,000 of capital gain income to Carlos and an extra $100,000 of ordinary income to Barb.
Sorry, but this allocation scheme involves a so-called transitory allocation that is generally disallowed by IRS regulations.
And More
Additional partnership tax allocation rules apply in specific circumstances. For instance:
Special rules apply to allocations related to contributed property, property differs from the tax basis (the usual situation).when the fair market value of the
Special rules may apply to allocations when the partnership has non-recourse debt, meaning debt for which no partner has any personal liability. Note that LLCs treated as partnerships for tax purposes usually have a special category of non-recourse debt called exculpatory debt.
You can’t make special allocations of federal income tax credits, because credits don’t affect partner capital account balances. The credits are simply passed through to the partners and taken into account on their personal returns. Therefore, federal tax credits must be allocated in proportion to each partner’s interest in the partnership—as determined in some reasonable fashion.
Takeaways
Making partnership tax allocations is pretty cut and dried in the simplest situations—such as when all tax items are allocated in proportion to stated partner ownership percentages and there are no complicating factors such as contributed property and non-recourse debt.
Not surprisingly, making partnership tax allocations is more complicated in more-complicated situations—including when you want to make special tax allocations. You must negotiate the federal income tax rules and regulations.
It can be done, but you must be careful to avoid the risk of future skirmishes with the IRS. That said, IRS audit rates for partnerships have been very low in recent years.
When putting together a partnership deal, don’t assume you can make tax allocations just any old way you want. You probably cannot. Consult a tax pro with experience in partnership taxation. It will be money well spent.