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. A limited liability company (LLC) classified as a partnership does not have a partnership agreement. What, then, determines how its allocations are made?
The broad construction of the term “partnership agreement” in Regs. Sec. 1.704-1(b)(2)(ii)(h) indicates that an LLC’s articles of organization, operating agreement, and any other agreements among the members (such as a capital contribution agreement) are to be examined to determine the members’ economic arrangement. This is illustrated by Letter Ruling 9622014, in which a withdrawing partner, while not explicitly released from her personal guaranty by a lender, 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 law 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 LLC tax return (Regs. Sec. 1.761-1(c)).
Time for Reporting a Member’s 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 as to how the income should be allocated (Burke, TC Memo 2005-297, aff’d 485 F3d 171 (1st Cir. 2007)). A problem may arise when there is an oral agreement as to the method for making LLC allocations.
Oral Modifications to an LLC’s Articles or Operating Agreement
Occasionally, members decide orally to change the LLC’s method of making allocations; Regs. Sec. 1.704-1(b)(2)(ii)(h) provides that such oral modifications are allowed. However, the modifications must be binding and made in accordance with the terms of the articles, operating agreement, or applicable state law (Kresser, 54 TC 1621 (1970)). The IRS will respect the modified method only if proof of the oral modification can be produced, and the modification is made according to the provisions of the LLC’s organizational documents or state law.
For LLCs formed in some states, oral modification is impossible; the state LLC act requires an LLC’s operating agreement or amendments to the operating agreement to be in writing. However, an oral agreement may be equitably enforced by the courts in those states or may be enforced as a contract executed by and among the members outside of the operating agreement. When this is not the case, oral modifications may be valid if each member agrees to the modification, but the IRS can still argue that the modification is invalid because it is not written.
Practice tip: If an oral modification has been made during the year, the practitioner should recommend that the modification be reduced to writing and signed by all members. Even if the state statute permits an oral modification, documentation of the members’ agreement is advisable for both legal and tax purposes. When memorializing an oral agreement, the practitioner should be careful not to backdate any documents. The proper way to memorialize an oral agreement is to prepare a document that includes the (1) date or approximate date (if the exact date cannot be verified) that the agreement was reached, (2) effective date of the agreement, (3) terms of the agreement that was reached, and (4) date the written agreement was actually signed. In no case should this be backdated to the date the oral agreement was reached. All parties to the oral agreement should sign the written agreement.
Example: Bill Blast, CPA, is engaged by the Rockyroad LLC to prepare its 2007 tax return. The Rockyroad operating agreement has a boilerplate provision that requires use of the safe-harbor allocation method to make allocations. The agreement further provides that amendments to the agreement require the written consent of all members. Sandy Hill, the member-manager of Rockyroad, has verbally indicated to Blast that the members have agreed for 2007 and thereafter to make allocations based on the members’ interests in the LLC. Because the LLC’s operating agreement provides a specific method of allocation and also contains a procedure requiring written amendments, Hill’s directive to change this method of allocation is probably not a valid oral modification of the agreement and would be disregarded by the IRS. Blast should tell Hill that the modification should be put into writing prior to the date the LLC’s return is filed.
The proposed modification would be binding if all the members signed an amendment to the agreement changing the method of allocation. However, because the safe-harbor method and the members’ interest in the LLC do not necessarily produce the same results, Blast should recommend that the LLC disclose to each member what impact the modification would have. Blast should also recommend that the members reduce their understanding to a written agreement or memorandum.
Reviewing the Organizational Documents
When a client forms an LLC, the practitioner should review the operating agreement and articles of organization to ensure the provisions for making allocations comply with the safe harbor or members’ interests in the partnership rules. If allocation provisions are not included in the articles or operating agreement, the provisions of the applicable state LLC act govern allocations among the members. When reviewing an operating agreement or articles of organization to determine the economic arrangement between the members, it is important to look at all sections that affect the actual dollars to be contributed by or distributed to the members. Special attention should be given to those sections dealing with capital contributions, capital calls, distributions of cash from operations, requirements for funding deficits, liquidation provisions, liability for debts (if any), and requirements for returning prohibited distributions.
When analyzing LLC documents to determine the underlying economic arrangement of the members, the practitioner must consider the agreement as a whole, not just the profit and loss allocations. Almost invariably, agreements that have suspect tax allocations attempt to treat an item of income or loss in one section of the document in a manner inconsistent with the treatment of that same item elsewhere in the agreement.
For example, in a suspect operating agreement, an allocation of an item of loss under the profit and loss provisions of the agreement may not have any effect on liquidating distributions (typically covered in another section of the agreement) that the members receive on the LLC’s termination. An agreement may, for tax purposes, allocate losses to one member while providing that distributions (including liquidating distributions) are shared equally. This is a classic example of an allocation that does not have economic effect. In such situations, it may be difficult to determine which section of the document takes precedence—if a member is allocated a tax loss, but the allocation does not affect his or her distribution rights, which provision controls? Generally, the contribution and distribution provisions of an agreement are deemed to control the profit and loss allocation provisions.
In the previous example, the tax-loss allocation would be coordinated with the distribution provision, not the other way around. Practitioners are cautioned against adopting interpretations of the agreement for tax purposes that may be inconsistent with members’ real economic agreement.
Reviewing the Tax Return
When a practitioner is preparing a return for an LLC client, the return must be prepared in a way that ensures the tax allocations will be respected. This requires a careful review of the governing documents and the appli-cable state LLC statute (if default provisions in the law apply). If the governing documents provide for tax allocations not valid under the rules, the practitioner must reallocate LLC items to reflect the members’ interests in the LLC. The practitioner should also notify the client of the problem, preferably in writing, and the documents should be amended to correct the problem. In addition, the members should be notified that the K-1 allocations were not made in accordance with the operating agreement’s provisions. This notification might be accomplished by a statement in the K-1 cover letter.If there are any problems with the documents, or allocations are made in reliance on the members’ interests in the LLC rules, it is advisable to put a disclaimer in the transmittal letter. A practitioner may be subject to malpractice charges if he or she does not warn the LLC management about the difficulties of complying with the safe-harbor rules. A practitioner who discovers invalid allocations in previously filed returns upon accepting a new client should advise the client that the returns should be amended. If the client does not agree, the practitioner should consider terminating the relationship with the client.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 12th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com).