Special allocations: Overview, definition, and example
What are special allocations?
Special allocations refer to the distribution of income, expenses, or tax benefits among business partners or shareholders in a way that differs from standard ownership percentages. These allocations are commonly used in partnership agreements, LLC operating agreements, and joint ventures to reflect specific contributions, risks, or agreements between parties.
For example, in a partnership where one partner contributes more capital while another manages daily operations, they may agree that the capital-contributing partner receives a larger share of profits than their ownership percentage would typically dictate.
Why are special allocations important?
Special allocations allow businesses to customize profit and loss distribution to reflect the real contributions and responsibilities of each party. Without them, profits and losses would typically be divided strictly based on ownership percentages, which may not always be fair or practical.
They are especially important for:
- Tax planning – Special allocations can optimize tax treatment for partners.
- Investor incentives – Investors may receive a larger share of initial profits in exchange for capital contributions.
- Risk balancing – Partners taking on more financial or operational risk can be allocated a higher portion of profits.
However, special allocations must comply with IRS rules (for U.S. entities) and other tax regulations to ensure they have substantial economic effect and are not simply designed to reduce tax liabilities unfairly.
Understanding special allocations through an example
Imagine two business partners start an LLC. One partner invests $100,000, while the other contributes only $20,000 but manages daily operations. Instead of splitting profits 50/50, they agree that the investing partner will receive 70% of profits until they recoup their initial investment, after which profits will be split more evenly.
In another example, a real estate investment partnership allocates 80% of depreciation tax benefits to one partner because they have a higher tax burden, even though they only own 40% of the property. This strategy helps the partnership maximize tax efficiency.
An example of a special allocations clause
Here’s how a contract might define special allocations:
“The Partners agree that all income, gains, losses, deductions, and credits shall be allocated in accordance with the provisions of this Agreement. Any special allocations shall be made in compliance with applicable tax laws and shall reflect the economic arrangement of the Parties.”
Conclusion
Special allocations provide flexibility in distributing profits, losses, and tax benefits based on business needs and partner contributions. They are especially useful in partnerships and LLCs where contributions and responsibilities vary. However, they must be structured carefully to comply with tax laws and ensure they have a legitimate economic purpose. Businesses should clearly document special allocations in agreements to avoid disputes and tax complications.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.