When you are starting a new business or attempting to reduce the tax bill for your existing business, how do you decide which entity type is right for you? Entrepreneurs these days tend to gravitate towards S corporations almost as a default, and certainly, this can be the right choice for certain businesses and comes with its own set of tax advantages. However, many new business owners overlook the partnership option simply because it’s a less familiar business structure or seems more complicated at-a-glance.
Partnerships offer a high level of flexibility and significant tax advantages that don’t come with other entity types. For this reason, entrepreneurs should familiarize themselves with the pros and cons of partnerships before making an election. Start by asking questions like:
• Where is the money going to come from to start this business? If the business has already started, who put what money and other assets into the business?
• Do you have an agreement in place outlining how each partner will share in the benefits and the burdens of business? This includes funding the growth of the business and meeting your debt obligations or covering expenses when your business is struggling to make ends meet.
Once you’ve defined your current status and needs, you will be in a good position to evaluate the benefits and drawbacks of each entity type. For instance, a major benefit of choosing a partnership structure is the ability to make special allocations. In this article, we will define special allocations and outline the tax advantages they offer.
What is a Special Allocation?
Special allocations are one of the most powerful features of the partnership. So how exactly do they work? A special allocation is an arrangement in which profits and losses are distributed to owners and partners in a way that benefits them, regardless of the percentage of the business they actually own. This means that partners can treat any items—such as income, deductions, gains, and losses—separately and divide them up however the partnership agreement dictates. This means that each person can receive the items that are most helpful for their personal tax situation.
Now with most tax planning strategies, the company needs a bona fide business purpose for claiming a benefit. Special allocations work differently—in this case, what is required is an economic impact that reflects real economic arrangements between the partners. According to the IRS, this is all that is needed for special allocations to be fully legal regardless of who is doing what in the business and what part of the business they own.
What is the Difference Between a Partnership and an S Corporation?
As a pass-through business, the partnership itself does not pay federal taxes. Instead, the partnership distributes income to the individual partners who then pay taxes via a Schedule K-1. This is similar to an S corporation, which is also a pass-through entity. A key difference is that the S corp does not allow special allocations. Instead, all items have to be split up according to stock ownership. There is no flexibility to decide who gets what—income, gains, losses, credits, and deductions all have to be allocated per-share, per-day.
How Can I Be Sure My Business Can Use Special Allocations?
The main requirement for using special allocations is that those allocations must have substantial economic effect. This simply means there are real economic consequences—the transaction has a financial impact. To prove this is present, you can apply two separate tests: the economic effect test and the substantial effect test.
Economic effect means that a taxpayer who receives a tax benefit must also receive an economic burden. Alternatively, a taxpayer who receives a tax burden must also receive an economic benefit. Overall, there has to be a give-and-take. However, the benefits and burdens each partner receives do not have to match. If a partner gets a depreciation deduction this year, that does not mean the other partner takes it next year. Instead, you can make an adjustment to the partners’ capital accounts in the amount of those special allocations. The key is that the income and losses even out in the eyes of the IRS.
The substantial test means that the allocations can not be transitory or shifting. One of the ways we prove this is by adjusting the capital accounts to reflect those losses, special deductions, higher income, or whichever item is allocated to that partner.
If you fail to pass both the economic effect test and the substantial effect test, the IRS is entitled to reallocate the tax items, which likely means splitting them up according to each partner’s ownership percentage just like an S corporation. This is why maintaining accurate capital accounts is absolutely critical if you want to see tax advantages from your partnership.
Why Use a Safe Harbor Agreement?
One way to ensure you meet the requirements and the IRS honors your special allocations is to use a safe harbor agreement. If your partnership agreement contains special boilerplate language, the IRS will automatically allow for these allocations. Without it, the IRS may challenge the special allocations and could reallocate certain items. There are three types of safe harbor agreements: basic, alternative, and economic equivalence. As the taxpayer, you don’t necessarily need to know the in’s and out’s of what makes these types different. The main thing to identify is the fact that you plan to do a special allocation and therefore that you need to include special language in your partnership agreement. Once you’ve identified that, the next step is to turn to an attorney to draft that partnership agreement as part of your implementation. This is crucial to get right, so make sure you rely on a specialist with the right skillset!
Summary
To make the most of the tax benefits that partnerships have to offer, be sure to:
1. Align tax and economic allocations
2. Maintain accurate capital accounts
3. Double-check that you have followed the IRS’ rules by applying the substantial economic effect tests
If you check the boxes above and have the arrangements clearly defined in your partnership agreement, you should be well on your way to enjoy the benefits of special allocations. If this setup sounds like it could save you money but your business is not currently structured as a partnership, consider an entity change.
For expert assistance in determining which entity type will provide you with the tax advantages you need, connect with a Certified Tax Planner today.
