If a business splits up profits and losses in a way that does not correspond to the owners' percentage interests in the business, it's called a "special allocation." The IRS pays careful attention to special allocations to be sure business owners aren't playing hide and seek with potential tax dollars -- for example, by allocating all business losses to the owner in the highest income tax bracket.
If the IRS rejects your special allocation, it will tax you and your co-owners as if you had divided profits and losses in proportion to your ownership interests, regardless of what your partnership agreement or operating agreement says.
Substantial Economic Effect
To be certain that a special allocation is legitimate, the IRS checks to see whether the allocation has what it calls "substantial economic effect." This jargon means that a special allocation must reflect the owners actual economic circumstances, not an effort to shift income around to reduce taxes.
Get Expert Help
Unfortunately, the IRS regulations covering substantial economic effect are complicated. If you want to set up a special allocation, you'll need expert help to make sure that your allocation will pass muster with the IRS. A good accountant or tax lawyer -- one who provides advice on this area of tax law as a regular part of her practice -- can draft special language for your partnership agreement or operating agreement to ensure that the IRS will accept your special allocation.
If you want some advice from a lawyer, Nolo's Lawyer Directory can help you find a local business lawyer.
