LLC Taxation – Economic Effect
As explained in my previous article, LLC Taxation – Distributive Share Part I, your distributive share in an LLC must
have “substantial economic effect”. Your distributive share satisfies the “economic effect” portion of this requirement if the operating agreement of your LLC (i) provides for the proper maintenance of capital accounts of the members, (ii) requires that liquidating distributions be made in proportion to the positive capital account of each member, and (iii) requires that each member with a negative capital account balance following a liquidation restore to the LLC the amount of such member’s capital account deficit.
Alternate Test for Economic Effect
If your operating agreement does not require you to restore to the LLC the amount of your negative capital account balance following a liquidation, then your distributive share can still have economic effect to the extent by which an allocation does not cause, or increase, a negative balance in your capital account as of the end of the LLC’s taxable year, if your operating agreement includes (i) and (ii) above, and if your operating agreement provides for a “qualified income offset”.
Qualified Income Offset
Your operating agreement contains a “qualified income offset” if it requires a prompt allocation of LLC income or gain to a member in the amount necessary to eliminate the member’s negative account balance that is unexpectedly caused by:
1. An adjustment for a depletion allowance related to oil and gas properties of the LLC,
2. An allocation of loss or deduction related to
a. A donation to the member of an interest in a family partnership
b. A change in the member’s membership interest, or
c. Unrealized receivables or substantially appreciated inventory allocated to the member, or
3. A distribution to the member to the extent that it exceeds offsetting increases to the member’s capital account, other than any increase resulting from a “minimum gain chargeback”.
Examples of Alternate Test for Economic Effect
For Example, you and your partner form an LLC, and each of you contributes $20,000 to the LLC. Each of you obviously starts off with a capital account balance of $20,000. Let’s say your operating agreement requires the maintenance of capital accounts, but it allocates distributions to each of you equally upon liquidation, and it does not require either member to restore the member’s negative account balance following liquidation. The operating agreement additionally allocates all of the LLC’s tax deductions to your partner. At the end of the first taxable year, your LLC’s income equals it expenses, and it has a $10,000 deduction, which is allocated entirely to your partner. Your capital account balance at the end of the first taxable year remains at $20,000, while your partner’s balance is $10,000. Because the allocation to your partner lacks economic effect, the IRS will disregard the allocation of the deduction and reallocate half to each of you.
If however your operating agreement (i) requires the maintenance of capital accounts, (ii) requires distributions following liquidation that are in proportion to the positive capital account balances of the members, (iii) provides for a qualified income offset, and (iv) if items 1, 2, or 3 above are not reasonably expected to cause or increase a negative account balance of any member, then the $10,000 deduction allocated to your partner in the example above will have economic effect.
Let’s assume the additional four facts above, except that the LLC’s deductions at the end of its second taxable year is $15,000. All of this amount is allocated to your partner, resulting in a negative $5,000 balance in his capital account at the end of the second year, assuming that the income and expenses of the LLC are equal. $10,000 of the $15,000 allocation to your partner will have economic effect, but the $5,000 portion that caused the negative balance to his capital account will not have economic effect. The IRS will therefore disregard the allocation to the extent of $5,000 and reallocate that portion of the deduction to you. If the deduction allocation to your partner at the end of the second taxable year of the LLC was just $10,000, then that full amount would have economic effect and would be allowed.
Minimum Gain Chargeback Has No Economic Effect
As stated above, minimum gain chargeback is not included as an offsetting increase to a member’s capital account. Minimum gain chargebacks occur in relation to nonrecourse liabilities of the LLC. A nonrecourse liability is defined by the Treasury regulations as (i) any liability of the LLC in which no member bears the risk of loss of the liability, or (ii) a liability of a member that is assumed by the LLC. “Partnership minimum gain” occurs when a nonrecourse liability is greater than the adjusted basis of the property encumbered by the nonrecourse liability. A reduction in partnership minimum gain, which occurs typically when the amount of a debt owed in paid down, results in a minimum gain chargeback to the extent of such reduction. Minimum gain chargeback does not have economic effect, because it’s an offset to the nonrecourse deductions that were previously claimed by the LLC. Minimum gain chargeback must be allocated to each member that was previously allocated a related nonrecourse deduction or that received a distribution attributable to nonrecourse borrowing.
Operating Agreement Requirements for Alternate Test for Economic Effect
As seen, you may not be able to entirely escape the requirement of making up a shortfall in your capital account, but you can dramatically avoid a reworking by the IRS of allocations by your LLC by including in your operating agreement:
1. The requirement that the capital account of each member be maintained in accordance with 26 CFR 1.704-1(b)(2)(iv).
2. The requirement that liquidating proceeds will be made in accordance with the positive capital account balance of each member.
3. No requirement that any member contribute to the LLC a negative account balance following a liquidation.
4. The requirement that members share profits and losses of the LLC in proportion to their respective ownership interests in the LLC.
5. A qualified income offset provision.
The information provided in this article is general in nature, and it is not intended as legal advice. Your circumstances may be unique, and you should therefore consult knowledgeable legal counsel about how the information or concepts discussed in this article might apply to you or your business.
Michael Sewell has an MBA and JD, numerous years of high level business experience with multi-billion dollar corporations, and he has practiced law in Missouri since 2005. Michael Sewell is the owner of Sewell Law, LC, which provides litigation, private securities offerings, and other legal services to businesses.
Feel free to contact Michael through www.stlouisllcattorney.com.
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This article was published on March 31, 2015.
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