Special profit allocation for multi member LLC

[csanch11]

Is it permissible by the IRS to have 2 businesses under a multi member LLC. All the profits of one of the business goes to one of the member, while all the profits of the second business goes to the other member?

[tagteam]

I sincerely doubt they care, but your allocation is required to have substantial economic effect independent of the income tax consequences thereof. 

You really should consult with a legal/tax professional and have an operating agreement drafted (if you have not already done so) because you are not exactly following the default rules for partnership interests and allocations. 

It is possible to get to the point where you have totally separate operating companies (businesses) but no actual partnership (i.e., you are not sharing in profits nor losses with your partner(s)).

[helpfuluser]

I don't agree with the first sentence. Substantial economic effect is not required, and, in fact, many (and probably most) new partnerships expressly do not use those rules. And, anecdotally, I've heard that IRS would love to more effectively audit partnership allocations. It's just really hard to do.

Agree with the second and third sentences (except that the poster likely *is* following the "default rules" for partnership allocations, since the special allocations seem to track the economic arrangement). The poster could ask a lawyer to draft an operating agreement that disclaims a tax partnership and treats each business as being owned by the relevant member for tax purposes. But it's a headache, and likely expensive. The poster might consider converting to a series LLC, if that's available, with each business in a separate series; this could be a nice, simple solution for both state law and tax purposes.

Kudos to @tagteam for noting the "no partnership" issue.

[Rick19744]

@helpfuluser I am not sure you have read the 704(b) regulations and if you have, then you do not understand them.

All partnership tax allocations must have substantial economic effect or the allocation is based strictly on the ownership in the partnership.  These rules are complicated and misunderstood by many.

The substantial economic effect rules come into play if there are special allocations, which appears to be the facts in the question.  If the special tax allocation does not have substantial economic effect, then the default is the allocation is based on the partner's interest in the partnership (PIP rules).

Your comment that most partnerships don't use those rules is because they allocate based on the PIP.

There are provisions that get around the substantial economic effect rules, but one of those provisions require a capital account deficit restoration clause in the partnership agreement / LLC operating agreement.  I have yet to see an LLC agreement that has that clause which is due to the limited liability of an LLC member.  There could be a provision for a qualified income offset, but once again, doubtful anyone preparing their own partnership return understands those provisions.  Finally, the capital accounts must be maintained in accordance with the 704(b) regulations and those capital accounts are NOT book capital account nor are they tax capital accounts.

If you are using any special allocations, then I strongly recommend you consult with a tax professional that understands the Section 704(b) rules.

[helpfuluser]

@Rick19744, thanks for the thoughtful response. I can be more concrete: under 1.704-1(b)(1), allocations in a partnership agreement are respected if they (1) have SEE, (2) are consistent with PIP, or (3) follow other rules not relevant here.

Let's say that A and B form a partnership. A puts in business X, and B puts in business Z. The businesses have equal values. Under the partnership agreement, A will receive all distributions, operating and liquidating, with respect to X, and B will receive the same from Z. A runs X, B runs Z, et cetera, such that the businesses are economically siloed. The partnership agreement says that allocations of all tax items will be 50-50 between A and B. The partnership allocations do not have SEE under either test.

In year 1, X has $60 of income, and Z has $40 of income. The partnership distributes $60 to A and $40 to B. The partnership allocates taxable income $50 to A and $50 to B. The allocation is not consistent with PIP, based on the factors relevant to the facts and circumstances test in 1.704-1(b)(3). Taxable income should be reallocated under PIP, $60 to A and $40 to B. Had the partnership agreement said, all taxable income from X is allocated to A and all income from Z is allocated to B, then the allocations *would* be consistent with PIP, and they *would* be respected by IRS.

Bottom line: you absolutely can have a situation under PIP where partners are allocated all tax items from specific businesses conducted by a partnership. But, it depends on the specific facts and circumstances. Note that, in my example, if the allocations complied with SEE (and they could, just not under the facts I outlined), then the 50-50 split in taxable income *would* be respected by IRS, even if, say, operating distributions were 60-40.

Another brief point: DROs and QIOs aren't used to "get around the SEE rules." They are part of the "economic effect" prong of SEE in -2(b)(2)(ii)(b) and (d). So you'd need to have one or the other to be under one of the two tests.

If you disagree, I'd love to hear what you think and your reasoning. Overall, I absolutely agree that professional advice is needed, but it's not accurate that the poster's proposed allocation always will fail to be respected. (I would mention series LLCs as a possible--and possibly cheaper--alternative to the partnership rules, however.)

[helpfuluser]

Ah, crickets. Some general thoughts for posters on this forum: Some of the advice posted here is good, and some really is not. Some of the bad advice could cost folks a lot of money. Overall, posters should be skeptical and ask follow-up questions. Google for information written by experts. Use the conversations in these forums to guide your own research. Seek cost-effective accounting or legal advice. Don't just rely on the words a few very active users spray across these forums.

[Critter]

If you are going to have such an intricate arrangement I HIGHLY recommend you seek local professional assistance to get things set up correctly and get educated on how to keep the books and complete the tax return.  Recommend a tax attorney or CPA/EA well versed in accounting and tax laws.  

[Rick19744]

Final comments:

• The attached commentary from a noted authority on partnership tax summarizes my points: In general, the Regulations provide that an allocation contained in a partnership agreement is valid if it satisfies one of three tests: (1) it has “substantial economic effect”; (2) it is in accordance with the partners' interests in the partnership, as determined by reference to all the facts and circumstances; or (3) it is “deemed” to be in accordance with the partners' interests in the partnership. Although the substantial economic effect test is not entirely objective, it should generally be viewed as a safe harbor test. If an allocation does not satisfy the substantial economic effect test, it may nevertheless be valid if it is deemed to be in accordance with the partners' interests in the partnership. If an allocation does not satisfy either of these tests, the items that are the subject of the allocation will be reallocated to comport with the partners' interests in the partnership.
• "Using getting around the SEE regulations" was not the best use or words, as the DRO's and QIO are alternate tests.  
• Your example does nothing more that supports the requirement to meet the 704(b) regulations.  No such facts were provided.  The forum is a place to provide guidance for questions, some of which are way too complicated to explain and are beyond the scope of the forum.  Responses are an attempt to provide some "English commentary" for complicated situations.  
• I don't believe that I stated anything about the allocations failing.
• Bringing up Series LLCs into something like this is only mudding the water as there is far less clarity on those arrangements depending on the facts.
• SU's don't "spray words" on this forum.  Responses, as noted above, are there to help provide TT users with guidance in a very complicated tax environment.  Additionally, this is not a tax seminar forum.  For me personally, I have taught partnership tax for decades, attend high level partnership seminars which are led by noted authorities in the partnership world; Cliff Warren Senior Counsel in the passthrough group of the IRS; Eric Sloan of Gibson Dunn and former head of Deloitte passthrough group, Jenny Alexander co-managing principal of the passthrough group for Deloitte, Chuck Levun, Michael Cohen and other noted experts in the passthrough world.
• This forum doesn't need "chest thumpers" trying to out do someone else.  Most responses that deal with complex issues end with the suggestion that they seek out a tax professional who can sit down one on one and go through their specific facts, which was EXACTLY my recommendation in my last sentence.
• End of my discussion on this matter.

[helpfuluser]

I mean, sure. It seems like you basically agree with my posts (except about series LLCs), though you don't want to say so directly. BTW, I'm pretty sure that it's "chest thumping" when you start a post with, "I am not sure you have read the 704(b) regulations and if you have, then you do not understand them." (Although maybe you meant to be ironic, given that you, by your own admission, garbled the rules in the rest of your post.)

For this poster, the plain(-ish) English answer probably should've been, "Yes, it may be permissible, but the allocation of (tax) profits needs to track the business arrangement. This issue is touchy, however, and many people simply would avoid having both businesses under one LLC. You should talk to a lawyer or accountant who can go through your specifics. But if that person says your allocation doesn't work (or can't work), ask why, ask for alternatives, and make sure you understand their answers."