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Setting Up a Special Allocation for Your Small Business

When running a small business, it's important to understand special allocations. These are special rules that business owners use to divide business income and expenses for federal income tax purposes.

Whether you're self-employed, part of a partnership, or own a limited liability company (LLC), these allocations impact your tax return. They're guided by tax law and business law, helping determine how much tax each partner or member pays.

The simplest business arrangements often involve a split of the profits and debts. These closely track each partner's contribution to the business. Consider a two-person partnership. In this partnership, each partner contributes the same amount of time and energy to daily operations. The partners will likely split profits 50/50.

However, if one of the partners contributed 75 percent of the start-up capital, they may not want to wait too long for a return on that extra investment. This is where special allocations come in. The following is a brief explanation of how special allocations adjust for such scenarios.

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What Is a Special Allocation?

Creating a special allocation for a business means dividing up profits and losses among members. This is done in a way that doesn't correspond to the members' actual ownership interests.

There are many legitimate reasons for businesses to do this, but the Internal Revenue Service (IRS) also knows that businesses can use a special allocation to inappropriately lessen the tax liabilities of its members. For that reason, the IRS will closely examine a business' special allocation to make sure that the business has a valid justification for it.

If the IRS denies a special allocation, it will ignore whatever the partnership or operating agreement for the business says and levy taxes on the members of the business according to the proportion of the member's ownership interest.

The IRS looks for a substantial economic effect to determine whether a special allocation is above board. A special allocation with a substantial economic effect reflects the actual economic situations of its members rather than an artificial attempt to shift tax liability in an advantageous way.

Understanding Allocation Rules in Partnerships and LLCs

In partnerships and LLCs, each partner's share of income, deductions, credits, and other tax items is often based on their own ownership percentage. This is outlined in the partnership agreement or LLC operating agreement. However, special allocation rules allow for a different distribution.

For example, Partner A in a real estate startup might receive more income due to extra work or investment, changing their share of taxable income. These allocations must align with the Internal Revenue Code (IRC), which the IRS publishes. They must also be reflected in each partner's capital account.

Tax Implications of Special Allocations

Special allocations affect how much federal income tax a business and its owners pay. They can lead to tax benefits, like lower taxable income or tax credits, but can also create tax consequences if not handled correctly. Allocations can involve:

  • Ordinary income
  • Capital gains
  • Depreciation
  • Contributed property's fair market value

It's crucial for business owners to understand how these allocations change their tax returns, especially for complex arrangements like liquidating distributions or allocations in limited partnerships.

Legal Considerations and Safe Harbor Rules

The IRC has safe harbor rules for special allocations. These rules ensure allocations respect a partner's economic interest in the partnership. If allocations don't meet these standards, they might be rejected by tax authorities.

This can lead to unexpected tax liabilities. Business owners should be aware of the legal aspects of special allocations. They should understand personal liability issues in general partnerships and the protection offered in limited partnerships and LLCs.

Get Legal Help Setting up a Special Allocation

Due to the complexity of tax allocations and the risk involved, it's wise to consult a tax professional. They can guide you through tax law, the IRC, and specific issues like capital gains or depreciation. They can also help with allocating installments for tax years.

A tax professional can also help with the tax return process for your business type. This way, you can make informed decisions about your business income. You can also ensure compliance with all relevant tax and business laws.

Contact a tax attorney near you to learn how they can help your business.

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