Flexible Economic Arrangements
We represent a number of entrepreneurs. The form of business entity that they most often choose to operate is an LLC that is treated as a partnership for income tax purposes. They recognize that the LLC is not a taxable entity, that there are no limitations upon who may invest in an LLC, and that an LLC is flexible enough to accommodate many kinds of economic arrangements among the members.
However, although it is true that the tax rules applicable to LLCs are intended to permit taxpayers to conduct joint business and investment activities through a flexible economic arrangement without incurring an entity-level tax, many taxpayers do not appreciate that an LLC’s members do not have unfettered discretion in allocating the related income tax consequences. Indeed, the IRS has promulgated some very complicated rules in order to prevent taxpayers from “abusing” the LLC structure.
Thus, it is imperative that the members of an LLC, as well as their advisers, have a basic understanding of the partnership/LLC allocation rules.
There Are Limits
Implicit in these rules are the requirements that the LLC must be bona fide and that each LLC transaction must be entered into for a substantial business purpose, that the form of each such transaction must be respected under “substance over form” principles, and that the tax consequences to each member arising from the LLC’s operations – i.e., from the allocation of such member’s share of the LLC’s items of income, gain, loss, deduction, or credit – must accurately reflect the members’ economic agreement and clearly reflect their income.
Accordingly, if an LLC is formed in connection with a transaction a principal purpose of which is to substantially reduce the members’ aggregate federal tax liability in a manner that is inconsistent with the partnership/LLC tax rules, the IRS can recast the transaction for federal tax purposes, as appropriate, to achieve tax results that are consistent with such rules. For example, the IRS can determine, based on the particular facts and circumstances, that to achieve the “proper” tax results, the LLC’s items of income, gain, loss, deduction, or credit should be reallocated.
As a general rule, each member is required to take into account on the member’s tax return his or her distributive share, whether distributed or not, of each class or item of LLC income, gain, loss, deduction or credit (“tax items”). This includes the member’s share of the LLC’s net, or “bottom line,” taxable income or loss. The character in the hands of a member of any such item is determined as if such item were realized directly from the source from which realized by the LLC, or incurred in the same manner as incurred by the LLC.
The Operating Agreement
A member’s distributive share of any LLC tax item is determined by the operating (“partnership”) agreement, unless otherwise provided by the Code or the regulations promulgated thereunder. Thus, the terms of the agreement are very important and should be closely reviewed to ensure that they accurately reflect the understanding among the members.
If the agreement does not provide for such an allocation, then each member’s distributive share of such item shall be determined in accordance with such member’s “interest in the partnership,” taking into account all the facts and circumstances relating to the economic arrangement of the members.
If the agreement provides for an allocation, the allocation shall be respected if it has substantial economic effect, or, if taking into account all the facts and circumstances, the allocation is in accordance with the members’ interest in the partnership.
In determining a member’s interest in the LLC, the following factors are among those that will be considered:
- the members’ relative contributions to the LLC,
- the interests of the members in economic profits and losses (if different than that in taxable income or loss),
- the interests of the members in cash flow and other non-liquidating distributions, and
- the rights of the members to distributions of capital upon liquidation.
To the extent an allocation to a member under the operating agreement does not have substantial economic effect, and is not in accordance with the members’ interest in the LLC, such tax item will be reallocated in accordance with the member’s interest in the LLC.
In general, the determination of whether an allocation to a member has substantial economic effect for tax purposes involves a two-part analysis: first, the allocation must have economic effect; and second, the economic effect of the allocation must be substantial.
In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the members. This means that in the event there is an economic benefit or economic burden that corresponds to the allocation, the member to whom an allocation is made must receive such economic benefit or bear such economic burden. Stated differently, tax must follow economics.
For example, if an LLC agreement allocates the loss for a year to one of two members, and it also provides that liquidating distributions will be made equally to the two members, the allocation may be said not to have economic effect since it did not cause the member (to whom the loss was allocated) to suffer an economic loss.
The applicable regulations provide that an allocation will have economic effect if, throughout the full term of the LLC, the operating agreement provides:
- for the determination and maintenance of the members’ capital accounts in accordance with the rules set forth in the Regulations;
- upon liquidation of the LLC (or of any member’s interest in the LLC), liquidating distributions are required to be made in accordance with the positive capital account balances of the members; and
- if such member has a deficit balance in his capital account following the liquidation of his interest, he is obligated to restore the amount of such deficit.
In general, the members’ capital accounts will be considered to be determined and maintained in accordance with the Regulations if each member’s capital account is increased by (1) the amount of money contributed by him to the LLC, (2) the fair market value of property contributed by him to the LLC (net of liabilities that the LLC is considered to assume or take subject to), and (3) allocations to him of LLC income and gain (or items thereof); and is decreased by (4) the amount of money distributed to him by the LLC, and (5) the fair market value of property distributed to him by the LLC (net of liabilities that such member is considered to assume or take subject to).
Of course, absent an outstanding balance on a promissory note contributed to the LLC by such member, or any obligation under the operating agreement or state law to make subsequent contributions to the LLC, it is rarely the case that any member will agree to restore a deficit in his capital account – no member wants to come out of pocket beyond his or her initial investment in the LLC. For this reason, the regulations provide an alternate test for economic effect; specifically, provided the capital account rules are satisfied, an allocation will be deemed to have economic effect – notwithstanding the absence of an obligation to restore a deficit capital account – if the LLC agreement contains a “qualified income offset.”
An LLC agreement has a “qualified income offset” if it provides that a member who “unexpectedly” receives a specified type of allocation (e.g., relating to depletion allowances) or distribution will be allocated items of income and gain in an amount and manner sufficient to eliminate the member’s deficit balance as quickly as possible.
Is it Substantial?
That an allocation has economic effect is not sufficient. In addition, the economic effect of the allocation must be substantial. Specifically, there must be a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the members from the LLC, independent of the allocation’s tax consequences.
The economic effect of an allocation in an LLC’s taxable year is not substantial if the after-tax economic consequences of at least one member may be enhanced compared to such consequences if the allocation were not contained in the agreement, and there is a strong likelihood that the after-tax economic consequences of no member will be substantially diminished compared to such consequences if the allocation were not contained in the agreement – in other words, there is a disconnect between tax and economics.
Thus, if there is a strong likelihood that the net increases and decreases that will be recorded in the members’ respective capital accounts for such taxable year will not differ substantially from the net increases and decreases that would be recorded in such members’ respective capital accounts for such year if the allocations were not contained in the agreement, and the total tax liability of the members (for their respective taxable years in which the allocations will be taken into account) will be less than if the allocations were not contained in the agreement.
In determining the after-tax economic benefit or detriment to a member, tax consequences that result from the interaction of the allocation with such member’s tax attributes that are unrelated to the LLC (for example, a member’s NOLs) will be taken into account.
This general rule is aimed at preventing certain abuses of the allocation rules that generate tax savings, but have a “neutral” effect from an economic perspective (where tax does not following economics). For example, an LLC holds highly-rated bonds that produce a steady stream of income; one member of the LLC has expiring NOLs; the agreement allocates all of the LLC’s income for one year to that member; the agreement provides that the LLC’s income for later years will be allocated to the second member until he or she has been allocated the same amount of income; the allocations do not have substantial economic effect.
The foregoing was a simplistic summary of the allocation rules applicable to LLCs that are treated as partnerships. Unfortunately, these rules are anything but simple; indeed, they are among the most complex ever promulgated by the IRS, and their application presents significant challenges to tax advisers, let alone to the taxpayer.
If there is one principle that the reader should retain, and that should guide him or her in reviewing the allocation provisions of any operating agreement, it is that the tax consequences must follow the economics of the arrangement. Generally, speaking, this basic rule should help to ensure that the tax consequences anticipated by the members will be respected by the IRS.