The Hidden Tax Benefits in Your LLC

When Kristy Crabtree presented to her grandfathervalue, he would have benefited from an $2,300 of tax
the idea of a joint real estate venture, all she knewsavings without any cost. Swede included the special
was that the real estate market was exploding, anddepreciation allocation in the L.L.C. operating agreement
she needed money to join in on the action. Herafter determining the unlikelihood of being forced to
grandfather, Milan Placko, better known as "Swede",sale the property at a loss.
had other ideas. Being a savvy real estate investor forTHE OUTCOME
the last forty years, Swede knew the intricacies of theThree years later, Swede and Kristy still own their
tax code. He agreed to the joint venture with hisinvestment property. But unlike some investors, they're
granddaughter, but not without taking advantage ofbenefiting from the positive cash flows and the extra
every possible tax incentive.tax breaks. Swede receives an additional tax break of
"I needed money and my Grandpa wanted to reduce$755 every year, while Kristy is well on her way to
his taxes," recalls Kristy - at the time, a junior in collegebecoming a savvy real estate investor just like her
majoring in political science. "I had no idea a real estategrandfather - having already purchased two more
investment could reduce someone's taxes."investment properties on her own.
SPECIAL ALLOCATIONSFINAL THOUGHTS
Experienced investors such as Swede know thatEnsuring special allocations have substantial economic
some real estate deals call for a more complex L.L.C.effect is a complex task, and obviously should be
operating agreement. To a large extent, an L.L.C.undertaken with the help of your lawyer and
agreement dictates what tax consequences anaccountant. Nevertheless, once put in place, special
investor should endure or benefit from. Most L.L.C.allocations can substantially lower your tax bill. The key
agreements simply state "split profits and losses basedto success is making sure the member who receives
on capital accounts" and accordingly taxes are paid onthe tax benefit is also receiving the economic burden.
these amounts. In most situations this type ofADDITIONAL ADVICE FROM THE C.P.A.
agreement is fine - it is simple and provides anAll LLC operating agreements include a section
equitable result.detailing how profits and losses will be shared between
However, in many situations it is better to speciallymembers. Most of the time, profits and losses are
allocate certain items of income or deductions. Swedeshared based on how much of the L.L.C. a member
decided to specially allocate all of the depreciation onowns. The IRS will always respect this type of
the property he and his granddaughter purchasedagreement, but this may not always be best for you. If
because he was in a higher tax bracket than hisyou want to make special allocations in your L.L.C.
granddaughter. Kristy was fine with this specialagreement, you need to make sure the special
allocation because Swede would later have toallocations have "substantial economic effect."
recognize the entire gain when the property was soldSubstantial Economic Effect
- the I.R.S. was fine with this special allocation becauseEnsuring special allocations have "substantial economic
Swede was taking on more risk by making this specialeffect" can be difficult. The criteria can change based
allocation.on a taxpayer's individual circumstances, but the
TAKING ON MORE RISKgeneral criteria can be broken down into two broad
After making the original assumption that the IRSrequirements - the L.L.C. operating agreement must
would respect the special allocation, Swede and Kristyinclude certain clauses, and the special allocations must
discussed the matter with his C.P.A. The C.P.A.be grounded in economic reality.
confirmed Swede's assessment and said thatThree Required Clauses For "Economic Effect"
something called "substantial economic effect" hadThe following three clauses, or clauses of similar
been met. The C.P.A. went on to explain that theeffect, need to be included in your L.L.C. operating
underlying premise behind "substantial economic effect"agreement in order for your special allocations to have
was that the person who benefits from the specialeconomic effect:
allocations is also the person bearing the economic"Capital accounts will be maintained in accordance with
burden.regulation 1.704-1(b)(2)(iv)." This is not a difficult
The underlying premise behind "substantial economicrequirement to meet; in fact, your accounts should
effect" is also the very same reason why peoplealready be maintained according to this regulation.
avoid special allocations. For example, in the case of"Liquidating distributions will be made in accordance
Kristy and Swede, Swede was bearing the economicwith positive capital accounts." Again, this is not a
burden by taking on more risk because if the realdifficult requirement to meet. This clause ensures an
estate deal would have gone sour, Swede would beequitable liquidation and is a standard clause in L.L.C.
out most of the money.operating agreements.
AN EXPENSIVE TAX BREAK?"Deficit capital accounts will be restored before
A closer look at Kristy and Swede's real estate dealliquidation." Careful, this is not a standard clause and
reveals how Swede was put at risk. When formingshould probably not be put into your L.L.C. operating
the L.L.C. Swede invested $15,000 and Kristy investedagreement. Fortunately, a qualified income offset
$5,000. Normally, Swede would receive 75 percent ofprovision can replace this clause. A qualified income
all of the profits and losses, including the depreciation,offset provision can be complex, but basically is a
and Kristy would receive 25 percent. However,projection that there will be enough future income to
because of the special allocations in the L.L.C.offset any deficit accounts and this future income will
operating agreement Swede was now receiving 100first be used to restore any deficit accounts. L.L.C.
percent of the depreciation.operating agreements should never require a member
Swede knew that if the investment propertyto indefinitely restore his capital accounts because then
decreased in value he would be the one taking thethe member no longer has limited liability.
economic loss. He calculated that if the $320,000Grounded In Economic Reality - "Substantiality"
property decreased in value by five percent afterThere are a number of different tests that may be
three years and for some unforeseen reason theyapplied to ensure a special allocation is substantial -
had to sell - the special allocation would cost him overmany of which are very subjective. All of the tax
$6,000. Granted, Swede also knew that he wouldallocations within the LLC operating agreement should
have received the tax savings of almost $2,300 frombe examined as a whole when testing for
the specially allocated depreciation, but $6,000 was ansubstantiality, and the underlying premise behind
expensive price to pay for $2,300 of tax savings."substantiality" is that the person who benefits from
On the other hand, Swede calculated that if thethe special allocations is also bearing the economic
property remained at the same value or increased inburden.