The practitioner's role in reviewing LLC allocations.

• Author: Ellentuck, Albert B.
• Position: Limited liability companies

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. An LLC classified as a partnership does not have a partnership agreement. What, then, determines how allocations are made? The broad construction of the term "partnership agreement" in the regulations (Regs. Sec. 1.704-1(b)(2)(ii)(h)) indicates that the LLC's articles of organization, operating agreement, and any other agreements among the members (such as a capital contribution agreement) are examined to determine the economic arrangement of the members.

Observation: This is illustrated in Letter Ruling 9622014, where, although a withdrawing partner was not explicitly released from her personal guarantee by a lender, she 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 statute 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 return (Regs. Sec. 1.761-1(c)).

Observation: The importance of clear and concise allocation provisions in an operating agreement was highlighted in a recent court case. In Imprimis Investors, LLC, 83 Fed. Cl. 46 (2008), a partnership agreement did not clearly define what constituted items of ordinary income, and a dispute arose over the allocation of short-term capital gains. The court held that "ordinary income" did not include short-term capital gains, even though such gains would be taxed at ordinary rates. By defining terms in the operating agreement by reference to the Code, members can avoid such disagreements.

Time for Reporting 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 regarding how the LLC's income should be allocated (Burke, 485 F.3d 171 (1st Cir. 2007)). This problem may arise when there is an oral agreement as...