Creating the right business structure depends on a number of factors, not the least of which is how income and expenses will be treated for tax purposes. Under Section 704 (b) of the IRS Code, a partner’s share of profits and losses shall typically be determined by a partnership agreement, except when:
(1) the partnership agreement does not provide as to the partner’s distributive share of income, gain, loss, deduction, or credit (or item thereof), or
(2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect.
This statute was passed to prevent partnerships from allocating profits and losses purely based on the most advantageous tax result, so there must be “substantial economic effect” to the allocation of profits and losses to the partners. It has to be a reflection of the real economic circumstances, not simply a redistribution of income to ensure taxes are reduced.
Imagine two individuals decide to create an LLC together. In most cases, the applicable regulations would require that the profits be split in half. However, if the partners make dissimilar contributions to the company, then a special allocation may be appropriate. For example, if one owner contributes all of the start-up funding and the other owner contributes only their time, it would be entirely possible for the members to divide the profits/losses based on a ratio that reflects their differing contributions to the business.
There are many gray areas in determining what constitutes “substantial economic effect”. The assistance of an experienced business attorney is critical if you wish to avoid the potential for penalties to be assessed, as special allocations are frequently examined closely by the IRS.
Contact the business attorneys at Gehres Law today to learn more about how we can draft an agreement which will help you avoid costly errors.