The special tax provisions included in the majority of partnership agreements such as limited partnership and limited liability company (LLC) operating agreements, exist to satisfy requirements regarding the regulation of partnerships as established within the Internal Revenue Code. These special allocation provisions can alter the bargained for agreement and understanding of the partners thus, creating disruption between the partners during the operation of the partnership. A Denver tax lawyer at The McGuire Law Firm can assist partners and partnerships in understanding the impact of special tax allocations.
The Internal Revenue Code allows a partnership to have flexibility regarding the partner’s pass through of income and loss. However, Internal Revenue Service will not respect allocations that do not have substantial economic effect. In short, substantial economic effect means that partnership allocations need to be passed through to the partners who receive or enjoy the benefit of the income or hold the economic burden associated with the partnership losses. The IRS can reallocate income or losses if the IRS determines an allocation or allocations do not have substantial economic effect.
The impact on the substantial economic effect regulations may be most apparent when looking at the limited partners in a limited partnership (or limited liability company). The benefit of limited liability can result in certain allocations lacking substantial economic effect in the eyes of the Internal Revenue Service. When considering the special allocations within a partnership agreement, one should note that a safe harbor is provided and can be satisfied in the partnership agreement with the inclusion of certain provisions as outlined below.
Non-Recourse Debt Allocations: Such provisions require that the allocation of losses and deductions to partners associated with non-recourse debt-financed property have substantial economic effect.
Partner Minimum Gain Chargeback: Such provisions apply when there are non-recourse liabilities that a partner bears the risk of economic loss. The minimum gain related to these liabilities need to be allocated to partners that previously received allocations of losses and deductions related to the applicable liabilities.
Distribution Triggered Special Allocations: Such provisions allocate gain and income to a partner that offset “excess” distributions received by the partner that would be in excess of the partner’s interest.
It is recommended that the partners or partnership consult with a business attorney or tax attorney to discuss the impact of special allocations and to draft the operating agreement of the partnership. The reallocation of income, loss, gain or deductions by the IRS can create negative individual income tax consequences to the individual partners. Our tax attorneys and business attorneys are available to consult you regarding these issues.