Splitting taxes/income between LLC members

[Chris Connery]

Hi all,

IS it legal for one member of a dual member LLC to claim all of the income/pay all of the taxes on their tax returns. Leaving the other partner not claiming the income/ not paying the taxes. This of course has nothing to due with trying to hide income or skirt taxes. Just two partners with two different circumstances in life. Any help is appreciated.

[Ashish Acharya]

@Chris Connery , 

What you are referring is the special allocation (rather than the allocation based on the partnership interest) of the partnership items. It is a very complicated area of the tax. 

Allocations of partnership tax items must meet one of the following two standards to be valid under the code

1. The allocations must be in accordance with the partners' interests in the partnership (PIP), or

2. The allocations must comply with the substantial economic effect (SEE) safe harbor rules or produce equivalent results to such compliance.

 These safe harbor rules contain capital account bookkeeping guidelines that establish uniform procedures for recording the economic (not tax) results of partnership operations. Once the economic bookkeeping has been done, the allocation of tax results among the partners must be made in a manner that is consistent with the allocation of the corresponding economic results.

For example, assume a partnership has two equal partners with identical economic capital accounts. If the partnership agreement allocates all economic gains, losses, and distributions 50/50 between the two partners, it cannot allocate tax items differently. 

If the partners agree to specially allocate one item (for example, capital gains) 80/20 for economic purposes per SEE safe harbor, the corresponding tax amounts must also be allocated 80/20.

However, IRS has a framework that can reallocate the partnership items based on the “ partner's interest in the partnership” if IRS determines the method of sharing the partnership items lacks the “Substantial Economic effect” (SEE) To meet the SEE, there are strict rules to maintain meaningful capital accounts including Deficit Makeup Requirement for those accounts.

With the requirement, the partner must at some point contribute sufficient capital to eliminate the deficit, and the partner has the burden of the loss that partnership has and the allocation of the partnership will be respected by the IRS.

This is a very high-level summary of the rules and is not comprehensive. there are many exceptions as well.

Since the substantial economic effect, safe harbor allocation rules are complex and requires considerable additional recordkeeping, it's easier to follow PIP standard. 

Disclaimer: While I’m a CPA, I’m not your CPA. What I wrote above does not create a CPA/client relationship between us. I wrote the above for informational purposes. Do not rely on it for tax advice. Always consult with your CPA before you rely on the above information.