As you well know if you are in a business or corporate partnership, the ownership shares are rarely as equal as standard 50-50 split. Unless you founded a company as a partnership, your ownership pool is more likely to reflect the personal history of each party involved. Even if you did start off with a 50-50 split between yourself and a partner, there’s a strong possibility that each of your ownership shares may have diluted down as you brought in more investors or managing partners. It’s in these scenarios of shared ownership where concerns over an inequitable distribution of profits and losses may arise. Every managing partner or investor in your business has some proverbial “skin in the game” when it comes to the company’s success. The compensation for each’s contribution (and conversely, the tax burden that each may face according to his or her profits) can be a hot topic for debate. The investors supporting your company no doubt feel as though their financial contributions warrant significant compensation. At the same time, they may view their tax burden to be unfair given that so many tax implications are dependent on the decisions made by managing partners. On the other hand, if you are one of these partners, you may feel that your contribution of your time and efforts in running the company deserves to be taken into account when determining how profits are shared. Any attempted agreement to disperse the profits and losses sustained by a company that differs from the owners’ actual ownership stakes is referred to as a special allocation.
How and When Are Special Allocations Enacted
Here is an example of possible scenario where a special allocation may be proposed:
You want to open up your own service shop, yet only have 30 percent of the necessary startup capital needed. You approach your father and ask him to provide the remaining 70 percent to establish the company as a limited liability corporation, with the promise of this being an investment opportunity. However, given that you’ll be running the shop, you both propose that you receive 70 percent of the profits and losses, while he gets only 30. To eliminate the potential of disadvantageous ownership agreements, it’s left to the IRS to determine whether a special allocation will be approved or not. When making this determination, the IRS looks primarily at the substantial economic effect of the situation. This essentially means that the unique economic situations of each member involved are reviewed before approving such a special allocation proposal. Your actual service contribution to the company may be given only cursory consideration. The example given here presents an interesting conundrum. You could be more likely to be approved based upon the fact that your current financial situation does not make owning your company outright possible. However, if the IRS believes your proposal is simply a way to shift the tax burden for company’s profits away from your father, it may be more likely to be denied. An alternative that could get you closer to approval would be to include language in your proposal that states your plan to use your increased profit share to buy 40 percent of your dad’s ownership stake within three years. This acknowledges your father’s increased financial contribution while outlining a plan to compensate him fairly in the short-term.
Concerning General Partnerships
An important note to remember regarding special allocations is that they require additional work if you are operating under a general partnership. Unlike an LLC, a general partnership inherently entitles all stakeholders to an equal share of profits and losses. Thus, a partnership agreement must first be in place that stipulates your profit sharing terms before a special allocation will be considered. Setting up a special allocation may be of particular interest to you, especially if you are majority shareholder in your company. The validity of such agreements, however, is not up to you. Being on board and transparent in all of your reasoning and justifications for such an agreement may increase your chances of gaining approval from the IRS.
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