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I have a question regarding the "LLC Percentage Used for Allocation to Schedule 1065 K-1". As I understand it, there are 3 choices for the 1065 K-1 "Percentage Used for Allocation to Schedules 1065 K-1": Profit %, Loss %, Capital %. I'm in the following situation. Lets say that there are 2 partners: Aaron and Bob. In 2008, both Aaron and Bob contributed $300 to the LLC to pay for formation expenses. There was no income for the LLC in 2008. In 2009, Aaron, paid for ALL the expenses and did ALL the work. The 2009 expenses were $2400, and so Aaron contributed $2400 to the LLC. And Aaron earned $600 for his work for the LLC in 2009. According to Aaron and Bob's LLC Partnership Agreement, the Profit % is determined by the percentage of work done toward projects that bring in an income. So it is both Aaron and Bob's understanding that Aaron should receive 100% of the profit. Aaron has a Capital % of 90%. Bob has a Capital % of 10%. How should the net loss of $1800 be allocated? Should the loss be allocated by "Profit %" or "Capital %"? If its distributed by "Profit %", Aaron would record an ordinary business loss of $1800, and Bob would record an ordinary business loss of $0. If its distributed by "Capital %", Aaron would record an ordinary business loss of $1620, and Bob would be allocated an ordinary business loss of $180. It would seem more fair that since Aaron did all the work, he should be able to deduct $1800 on his 1040. Is it appropriate to allocate according to a 100% / 0% Profit % in this case if both partners are okay with it according to the partnership agreement? Aaron and Bob are in full agreement that if it is proper tax-wise to do so, Aaron should be able to deduct $1800 by allocating the 1065 K-1 according to "Profit %". But is it okay to do so as far as the IRS is concerned? Or should the loss be allocated according to "Capital %", in which case Aaron would only be able to deduct $1620? Thanks |
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First - this sounds an awful lot like a homework problem, which I'm disinclined to do. But I'll give you some input anyway. First you do NOT get three CHOICES - there are three CATEGORIES that must be allocated, based on the operating agreement. These are Profit, Loss and OWNERSHIP of Capital. This is based on their original contributions of capital, not the current balance of their capital accounts. This can be a bit tricky, especially for the uninitiated. So think of the Capital Percentages as the person's percentage of OWNERSHIP - doing so will make it easier to follow the rest. Keep in mind too that just because one member may put in more money, that, by itself, does not automatically entitle them OWN more of the company than they did prior. Otherwise, simply contributing a few dollars could allow the balance of power and control to shift, perhaps even radically. Next, you need to understand that it doesn't really matter WHAT the operating agreement says AS LONG AS all the owners agree IN WRITING that they are going to allocate profits and losses different FOR THE CURRENT PERIOD. So the OA could say that I'm a 50% owner but that I'm entitled to 90% of the losses, 50% of the profits and 100% of the depreciation on assets that I contribute to the LLC. And if all the members agree, I could be allocated NONE of the losses, ALL of the profits, and NONE of the depreciation for the period in question. This brings us, in a round about sort of way, to the crux of your question, and my answer. Look to the operating agreement for guidance on how to allocate profits and losses. And if the members don't like what the operating agreement says they CAN change it - for this one year by reducing what they want for the year to a writing, or for all future years by amending the current, or drafting a new, operating agreement. Now, you didn't ask, even though it is germain to the discussion, about basis. In your example, one member put in $300 and the other put in $2,700. The is only PART of their basis, but let's assume that's all there is. The member with $300 in basis cannot deduct losses in excess of this amount EVEN if they are propertly allocated to him. Loss deductions are limited to basis - excess losses are suspended and carried forward to years when there is income. If the business shuts down before suspended losses are utilized they may be lost forever. You also have not told us whether the $600 in earnings reported to Aaron were classified as Guaranteed Payments or not. This throws another wrinkle into the equation as guaranteed payments to a member reduce the pass through income to ALL members pro rata based on what the operating agreement says about how income/loss is passed through. Nifty question though, good luck. 1
Thanks EAgent! Great answer!
Believe it or not, it is not a homework problem.
Its the situation I'm currently in, and I'm the Aaron character.
I should have clarified that Aaron didn't withdraw or receive $600.
Aaron performed consulting services for a client,
and the client paid the LLC $600. Aaron didn't make any withdrawals. However, for tax purposes, the income of $600 needs to be allocated, as well as the $2400 loss which needs to be allocated. And that's what my question is about.
(23 Mar '10, 20:58)
taxstudent
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+1 for this being a REAL question and not a homework problem. Great stuff! LOL