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Special Allocations for Partnerships

A special allocation is a financial arrangement that is set up in a partnership or LLC that restructures the manner in which profits and losses are distributed to the owners or partners in a way that does not correspond to their actual percentage interests in the business. Special allocations are often used in partnerships to compensate one or more of the partners who have provided a greater initial investment by granting them an increased share of the profits above their ownership percentage as allocated by the partnership agreement.

Taking Additional Profits in Lieu of Ownership

It is not uncommon for one or more of the partners to initially invest a greater amount of capital into the partnership during the startup phase of the business. Rather than assigning the partner a larger percentage of ownership in the partnership agreement, the company can make use of special allocations to pay that partner a larger percentage of the profits in order to repay the higher level of initial investment. Special allocations are created aside from the regular partnership agreement and are very important for tax filing purposes.

Expect Greater Scrutiny from the IRS

Because special allocations alter the profit and loss ratios between the various owners of a company or partnership, the IRS generally applies greater scrutiny to these situations. For the IRS to consider a special allocation "appropriate" the allocation must clearly reflect the economic circumstances of the individual owners and cannot be used in any manner to manipulate income or loss in order to reduce taxes.

Special Allocation Rejected

If the IRS rejects the special allocation, it will tax all of the members of the partnership according to their percentage of ownership interest regardless of the amount of profit they may or may not have received.

Time Is of the Essence in the Partnership Agreement

Special allocations are generally used on a limited basis until the partner has been compensated for their initial investment. If Partner A invests $100,000 into the partnership upon startup yet maintains an equal ownership percentage of the business, a partnership agreement can be created to state that Partner A will receive 75 percent of the partnership profit until the initial investment is repaid.

For tax purposes, it is important for this agreement to be as precise as possible regarding the amount of time the special allocation will be in effect for. It is advisable to consult with a tax attorney or investment specialist to ensure that any special allocations developed for a partnership or LLC are constructed according to the strict stipulations laid out by the IRS.