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 to the method for making LLC allocations.
Oral Modifications to Articles or Operating Agreement
Occasionally, members orally 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 T.C. 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, an oral modification is impossible because the state LLC act requires an LLC’s operating agreement or amendments to the operating agreement to be in writing. (However, a court may equitably enforce an oral agreement in those states or may enforce the agreement as a contract executed by and among the members outside the operating agreement.) When this is not the case, however, oral modifications may be valid if each member agrees to the modification, although the IRS can still argue that the modification is invalid since it is not written.
Where an oral modification has been made during the year, the practitioner should recommend that it be reduced to writing and signed by all members. (Even where the state statute permits an oral modification, the 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 (1) the date or approximate date (if the exact date cannot be verified) that the agreement was reached, (2) the effective date of the agreement, (3) the terms of the agreement that was reached, and (4) the 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: B, a CPA, is engaged by R LLC to prepare its 2011 tax return. The R 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. H, the member-manager of R, has verbally indicated to B that the members have agreed for 2011 and thereafter to make allocations based on the members’ interests in the LLC.
Since the LLC’s operating agreement provides a specific method of allocation and also contains a procedure requiring written amendments, H’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. B should tell H 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, since the safe-harbor method and the members’ interest in the LLC do not necessarily produce the same results, B should recommend that the LLC disclose to each member what impact the modification would have and 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 the Regs. Sec. 1.704-1(b)(3) rule regarding partners’ interest in a partnership. If allocation provisions are not included in the articles or the operating agreement, the provisions of the applicable state LLC act govern allocations among the members. When reviewing either an operating agreement or articles of organization to determine the economic arrangement between the members, it is important for the practitioner 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. 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 upon termination of the LLC. 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 example earlier, 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 the real economic agreement of the members.
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 applicable state LLC statute (if default provisions in the law apply). If the governing documents provide for tax allocations that are 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 practitioner should notify the members that the Schedule K-1 allocations were not made in accordance with the operating agreement’s provisions. This notification might be accomplished by a statement in the Schedule 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. If a practitioner, in accepting a new client, discovers invalid allocations in previously filed returns, he should advise the client that the returns should be amended. If the client disagrees, the practitioner should consider terminating the relationship.
This case study has been adapted from PPC’s Guide to Limited Liability Companies, 16th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.