LLC Profit % split

[Jesse]

An LLC w/ 2 members filing form 1065 changes the Profit/loss percentage each year their tax return is filed because one member needs to keep their income below a certain amount. For example in 2002 LLC profit is $40,000 so split 50/50, 2003 profit was $60,000 so split 67%/33%, 2004 profit was $50,000 so split 60%/40% and in 2005 profit of $70,000 so profit is split 70%/30%.

In my opinion this seems to constitute fraud or even tax evasion. There is no written agreement as to why the % of P&L is changed each year, it just appears one of the members needs to keep the income around $20,000. Has anyone else dealt with a situation such as this? Have any opinions as to what problems this may present, if any?

[jainen]

perfectly proper

>>seems to constitute fraud or even tax evasion<<

It's not a valid allocation if the purpose is to establish a tax position (i.e., maximizing EIC). There are any number of other possible reasons, however, like college financial aid and family support. Or it may be limited by time and work each partner contributes each year, which is perfectly proper.

[Jesse]

>>seems to constitute fraud or even tax evasion<<

There are any number of other possible reasons, however, like college financial aid and family support.

In this case I think family support is the issue - low income so low child support payments. There is a fall out between the two members, and much like a divorce, difficulty in coming to terms on a split. This is not my client and I'm only hearing one side of the story but I thought the change in % split every year is odd.

Guaranteed payments for time and work contributed were paid in the form of "wages" reported on a W-2 for each of the members, which is not correct, and the "net income" is split by % to make sure one member is consistently at approx $20,000.

My only advice was to get a good lawyer!

[Unregistered]

There is no reason the allocation can't be changed from year to year but some form of a written agreement would be helpful. You need to be concerned with the tax reporting and any other problems outside that box are not your concern.

[Unregistered]

In this case I think family support is the issue - low income so low child support payments. There is a fall out between the two members, and much like a divorce, difficulty in coming to terms on a split. This is not my client and I'm only hearing one side of the story but I thought the change in % split every year is odd.

Guaranteed payments for time and work contributed were paid in the form of "wages" reported on a W-2 for each of the members, which is not correct, and the "net income" is split by % to make sure one member is consistently at approx $20,000.

My only advice was to get a good lawyer!

Lower your income so you can make sure your kids are raised in poverty. Nice parent.

[OldJack]

There is no reason the allocation can't be changed from year to year but some form of a written agreement would be helpful. You need to be concerned with the tax reporting and any other problems outside that box are not your concern.

I have to disagree. Allocation can't be changed from year to year only for purpose of avoiding taxes. In this case I would bet the members splitting the profits are related. There has to be a valid business reason... not just a personal reason. When you sign the tax return you are saying with "the best of your knowledge and belief". That includes your knowledge out of the box.

[Bees Knees]

I agree with OldJack on this one. TTB, page 20-4 says: “If there is no special allocation contained within the partnership agreement, the partner’s distributive share equals the partner’s percentage of ownership interest in the partnership.”

This statement is supported by IRC Section 704(b).

In other words, you can’t play with special allocations unless you spell them out in the partnership agreement. Without these special allocations spelled out in the partnership agreement, you have to allocate income and deductions on the K-1 based on ownership interest. If these two partners are equal owners without a partnership agreement, that means they each owe tax on 50% of the profits each year. No exceptions.

[jainen]

I also agree

Yes, I also agree. The additional information Jesse gave that the guaranteed payments are calculated separately is important. They can't play with profit allocations this way, and their purpose is disgusting.

[Bees Knees]

Even if you do spell out the special allocations in the partnership agreement so that one partner makes the exact same amount each year ($20,000 per year in this case), that would still be shot down by IRS. Section 704(b)(2) says the special allocation must have substantial economic effect. In other words, something has to be done to counter the unequal special allocations so that it all equals out in the end.

An example of this rule is when a partner contributes property with an unequal FMV and tax basis. One partner may receive a special allocation of depreciation to counter the otherwise loss of the depreciation benefit to the partner who contributed cash.

You can't just make up special allocations to help one partner avoid tax. They have to make economic sense.