Advanced Tax Strategies for LLCs and Partnerships

Chapter 1Allocation of Partnership and LLC Income Under Section 704(b)

Learning objectives

• Analyze a partnership or LLC agreement to determine whether any special allocations in the agreement will be allowed under the Title 26 U.S. Code of Federal Regulations (CFR) Section 704(b) regulations, and when they will not be recognized by the IRS).
• Identify the potential economic consequences of special allocations to a partner or LLC member.
• Recognize the sections of a partnership agreement that must exist in order for a special allocation to be valid.
• Identify the potential tax consequences when a partner or LLC member has a negative balance in his or her capital account.
• Recognize the relationship between partnership and LLC allocations of profit and loss and the allocation of the risks and rewards of entity operations.
• Distinguish between the requirements for substantiality and those for economic effect under the regulations and understand the importance of future expectations when determining whether a proposed allocation will be both appropriate to achieve the economic objectives of the partners or members and legitimate under the Section 704(b) regulations.

Introduction

Section 704 affords investors a wide degree of latitude in dividing partnership and LLC profits and losses. Section 704(a) allows the partners or members to divide items of entity income or loss in any manner they choose,¹ subject only to the constraints of Sections 704(b) and 704(c).² Section 704(c) requires ...