Ensuring that allocations of LLC tax items are respected.

• Author: Owen, Sheila
• Position: Limited liability companies

Allocations of limited liability company (LLC) tax items (assuming the LLC is classified as a partnership for federal income tax purposes) must be made under one of two allocation methods to be valid under Sec. 704(b) and the related regulations (Regs. Sec. 1.704-1(b)(l)(i)):

* The allocations must be in accordance with the members' interests in the LLC (technically called PIP--for partners'interests in the partnership); or

* The allocations must be made in accordance with the substantial-economic-effect safe-harbor rules.

These two methods of validating allocations are separate alternatives. The tax allocations need not have substantial economic effect; it is only necessary that the tax allocations be in accordance with the PIP. The substantial-economic-effect rules are strictly a safe harbor.

Substantial-economic-effect safe harbor

Because the rules for determining members' interests in the LLC are broad and general, the regulations provide an alternative safe harbor--the substantial-economic-effect rules--with which an LLC can comply. These safe-harbor allocation rules contain the capital account bookkeeping rules for recording the economic (not tax) results of LLC operations. Once the economic bookkeeping has been properly done, the allocation of tax results among the members must be made in a manner consistent with the allocation of the corresponding economic results.

For example, assume two equal members own LLC interests all year and have identical book capital accounts. If the operating agreement allocates the overall economic gain and loss between the two members 50/50, it cannot allocate the tax results differently. Likewise, if the members agree to specially allocate one item for economic purposes, they must allocate the associated tax results for that item in the same way.

Following the safe-harbor rules may require a considerable amount of additional recordkeeping and analysis to maintain separate book (economic) capital accounts and make required revaluations of LLC property and member capital accounts.

Certain tax allocations do not have any corresponding economic element. Examples include allocations of tax credits, percentage depletion in excess of cost, and deductions related to nonrecourse liabilities. Safe-harbor allocations of these items must be made in accordance with PIP under special rules set forth in Regs. Sec. 1.704-1(b)(3).

Sec. 704 is not the exclusive test for determining the validity and consequences of a tax allocation. Other tax principles also must be considered, such as whether the allocation involves an assignment of income, misallocation of income among related parties (see Sec. 482), LLC interests created by gift (including a purchase by a family member) (see Sec. 704(e)), employee compensation (see Secs. 83 and 707(a)), a gift (see Sec. 2501), or a sale (see Secs. 707(a) and 1001). In other words, while an allocation may satisfy the Sec. 704(b) rules, other Code sections and related IRS guidance may still affect the tax treatment of that allocation.

Economic...