One advantage of running a business as a partnership is the right to make special allocations of tax items among the partners. You get the same option if you run your business as an LLC taxed as a partnership. This guide explains how special allocations work and why they matter.
What are special allocations?
A special allocation divides an item of partnership income, gain, loss or deduction in a way that differs from the partners’ overall ownership. Usually, ownership means each partner’s share of distributions and capital under the partnership agreement.
Example: Partner A owns 25% of the partnership. However, the agreement gives Partner A 80% of this year’s tax loss. That is a special allocation.
How pass-through taxation works
First, the partnership allocates its tax items among the partners, including any special allocations. Then it reports each partner’s share on Schedule K-1. Next, each partner reports those amounts on their own return, such as Form 1040.
The partnership itself pays no federal income tax. Instead, the partners pay tax. That is why it’s called pass-through taxation.
Key point: S corporations also use pass-through taxation. However, they can’t make special allocations. Instead, they must allocate every item strictly by stock ownership. So special allocations are often a key reason to choose partnership status over S corporation status.
How special allocations work in practice
Here is a common arrangement. In the early years, the business expects losses. So the agreement gives a larger share of those losses to the partners who can use them most. Often, these are the partners who put in most of the capital, and they may be passive investors.
Meanwhile, the partners who run the business get a smaller share of the early losses. For example, they may be the general partners of a limited partnership.
Later, the business expects to earn income and gains. At that point, the agreement gives a larger share of the income to the partners who took the early losses. Once that income offsets the earlier losses, all items go back to being shared by ownership percentage.
Over the life of the partnership, each partner’s total allocations usually match their ownership. In other words, special allocations mainly change the timing of when partners report income and losses. You can also specially allocate specific items, such as depreciation, instead of overall losses.
Special allocations must have economic substance
The IRS won’t respect a special allocation just because the agreement says so. Under Section 704(b), the allocation must have “substantial economic effect.” In short, it must match the partners’ real economic deal, including how capital accounts are kept and how cash is paid out when the partnership ends. Otherwise, the IRS can reallocate the items based on the partners’ actual interests. For background, see IRS Publication 541, Partnerships.
Get help with special allocations
Special allocations are powerful, but the agreement must be drafted carefully. We help partnerships and LLCs design allocations and prepare K-1s. To discuss your situation, call (415) 842-2940 or book a free 15-minute call.