The limited liability company (LLC) legal structure is a popular one among entrepreneurs. Founders may enjoy limited personal liability while avoiding double taxation present with traditional corporations. The Internal Revenue Code (IRC) also offers flexibility among LLC members (owners) when it comes to allocations of profits, gains, losses, deductions, and credits.
With great flexibility, however, comes great responsibility. The first responsibility of LLC members is to actually create a robust Operating Agreement and sign it. A well-negotiated LLC Operating Agreement allows members deduct losses or apply tax credits that might not be inferred under their original capital contribution percentages.
For instance, consider a partner who contributes 40 percent of the startup capital for an LLC. This member, however, doesn’t plan to engage in the company’s day-to-day operations, while the other partner who contributes 60 percent of the capital will completely run the business. The partner that runs the business might want to be allocated more profits or deduct more losses in a manner that is not in proportion to ownership percentages to more accurately reflect the partners’ involvement in the business. Without an Operating Agreement that stipulates that arrangement, this will not be the case, and the IRS will use a “facts and circumstances test” to determine allocations.
The IRS will actually use this “facts and circumstances test” even if you have an Operating Agreement, and the allocations of profits, losses, and other tax attributes are not identified under the applicable provisions of the Internal Revenue Code. Therefore, the IRS may be able to allocate profits and losses in a way that doesn’t reflect your intention even if you have an Operating Agreement!
Facts and Circumstances
If an LLC’s members do not spell out allocations in the Operating Agreement, the IRS will determine allocations based on each member’s “interest in the partnership.” To do this, the IRS uses the aforementioned facts and circumstances test. Items that are typically considered in the facts and circumstances test include:
- Each member’s general contributions to the LLC
- Each member’s interests in economic profits and losses (relative to interests in taxable income or losses)
- Each member’s interests in non-liquidating distributions
- Each member’s right to receive capital upon liquidation of the company’s assets.
Those four items are supplemented by many other factors considered by the IRS. In reality, the facts and circumstances relevant to determining allocations is whatever the IRS wants to consider. To save yourself, your business, and the other members from the whims of a federal agency, make sure you create and sign a comprehensive Operating Agreement.
Substantial Economic Effect
In any LLC taxed as a partnership, the IRS will ensure that allocations are in accordance with substantial economic effect. Generally speaking, this means that a member who experiences a loss must actually pay out that loss. The IRS will look to make sure that tax allocations follow the company’s books and that allocations affect the dollar amounts lost or gained by members.
Conclusion
Not having an Operating Agreement can harm your LLC for many reasons. Besides setting out each member’s obligations, it can ensure tax allocations that satisfy IRS regulations. For your Operating Agreement to actually serve your LLC, though, you must collaborate with business and legal professionals.
Attorney Tyler Q. Dahl has a unique blend of legal, tax, and financial proficiencies. This allows clients—California businesses and individuals alike—unparalleled guidance. We look forward to speaking with you soon.
Dahl Law Group
