When it comes to choosing an entity type, many entrepreneurs are drawn to S corporations and may make an election without truly weighing the pros and cons of each option. Business owners may not think to ask their tax planner for advice on business structures, but offering your expertise early in the process can help your clients save significantly on their tax bill down the road. For instance, partnerships are an often overlooked option that offer significant tax advantages that cannot be accessed with other entity types.
Tax planners can kick off the process of entity selection by asking good questions like:
• Where will the money to start this business come from? Or for existing businesses, who put what money and other assets into the business?
• Is there already an agreement in place outlining how each partner will share in the profits, losses, and overall obligations of the business? For instance, how will business growth be funded or who will be responsible for meeting debt obligations?
Once you have a sense of your client’s needs and what they have defined in their business so far, you can provide guidance on the entity types that would provide the best tax advantages. In the case of partnerships, one of the main benefits is the ability to make special allocations. Below, we’ll explore the reasons why special allocations might be a deciding factor in choosing the partnership structure and how they work.
So what is a special allocation? This arrangement allows partners to distribute profits and losses in a way that benefits each partner. With a partnership, there is no restriction based on who owns what percentage of the business. Everything from income and deductions to gains and losses can be divided up by simply outlining that in the partnership agreement. Unlike other tax planning strategies, the only business purpose a partnership needs to claim a special allocation is what is called “economic impact.” This simply means that the economic arrangements need to reflect how the partners are affected financially—more on that below.
This benefit can give partnerships a leg up over other entity types. Though partnerships and S corporations are both pass-through businesses, S corporations do not allow for special allocations. With an S corporation, all income, gains, losses, credits, and deductions have to be allocated according to stock ownership.
To make use of special allocations, partnerships must be able to demonstrate substantial economic effect. The transactions must have real economic consequences for those involved, which the IRS evaluates based on two tests: the economic effect test and the substantial effect test.
Economic effect, simply put, means when a taxpayer receives a tax benefit from a special allocation, they must also receive a tax burden—and vice versa. This does not mean each partner needs to receive the exact same benefits and burdens. Just because one partner receives a depreciation deduction this year does not mean the other partner has to get it the next year. To create this balance as the tax planner, you can simply adjust the partners’ capital accounts to even things out from the perspective of the IRS.
The second test relates to substantial effect. This means the allocations cannot be transitory or shifting. Again, we can rely on the capital accounts to lay out which items are allocated to which partner. If a partnership passes this test and the economic effect test, those special allocations are safe. If not, the IRS can reallocate those items according to each partner’s ownership percentage, essentially turning the company into an S corporation. If your clients opt into a partnership, be sure to emphasize the importance of maintaining accurate capital accounts.
Safe Harbor Agreements
In the context of special allocations, a safe harbor agreement uses special boilerplate language to help meet the requirements of the IRS. With this agreement in place, the IRS will automatically allow for your special allocations. The three types of safe harbor agreements are basic, alternative, and economic equivalence. We won’t go into the differences in detail here, but suffice it to say that as long as you are able to explain the value of a safe harbor agreement to your clients, this is where your role likely ends. The next step is to connect the taxpayer with an attorney to draft that partnership agreement. Your job is to emphasize the value of special allocations as part of the tax plan and identify the need for an agreement with clear language that will be honored by the IRS.
Summary
The key to securing benefits from a partnership is to:
1. Align tax and economic allocations
2. Maintain accurate capital accounts
3. Follow the IRS’ rules
This includes applying the substantial economic effect tests and clearly defining the economic arrangements via an official partnership agreement. To execute this tax strategy, taxpayers will need the assistance of a tax professional and an attorney to ensure all the requirements for special allocations are met.
The more familiar you are with the benefits of a partnership, the better able you will be to advise on whether an entity change should be part of your client’s tax savings strategy. To learn more about partnerships and the tax benefits that come with each entity type, sign up to become a Certified Tax Planner today.
