The CPA's role in reviewing LLC allocations.

• Author: Mares, Michael E.
• Position: Case Study

Sec. 704(a) provides that a partner's allocation of taxable income, gain, loss, deduction, and credit is determined in accordance with the partnership agreement. A limited liability company (LLC) classified a partnership does not have a partnership agreement. What, then, determines how its allocations are made?

The broad construction of the term "partnership agreement" in Regs. Sec. 1.704-1(b)(2)(ii)(h) indicates that an LLC's articles of organization, operating agreement, and any other agreements among the members (such as a capital contribution agreement) are to be examined to determine the members' economic arrangement.This is illustrated by Letter Ruling 9622014, in which a withdrawing partner, while not explicitly released from her personal guaranty by a lender, entered into a "hold harmless" agreement with the purchasing partner that effectively extinguished her liability. The IRS took this agreement between the two individuals into account to determine that the taxpayer constructively received a cash distribution.

In addition, the applicable state LLC law may determine how allocations among members will be made. State law is important in analyzing LLC allocations because many LLCs rely on default provisions included in the state LLC act.

Amendments to an LLC's articles of organization or operating agreement that affect a specific LLC year can be made up to the due date (not including extensions) for that year's LLC tax return (Regs. Sec. 1.761-1(c)).

Time for Reporting a Member's Distributive Share

A member in an LLC taxed as a partnership must report his or her share of LLC income in the required year, regardless of whether the income is actually distributed or whether there is a dispute among the members as to how the income should be allocated (Burke, TC Memo 2005-297, aff'd 485 F3d 171 (1st Cir. 2007)). A problem may arise when there is an oral agreement as to the method for making LLC allocations.

Oral Modifications to an LLC's Articles or Operating Agreement

Occasionally, members decide orally to change the LLC's method of making allocations; Regs. Sec. 1.704-1(b) (2)(ii)(h) provides that such oral modifications are allowed. However, the modifications must be binding and made in accordance with the terms of the articles, operating agreement, or applicable state law (Kresser, 54 TC 1621 (1970)). The IRS will respect the modified method only if proof of the oral modification can be produced, and the modification is made according...