Limited Liability Companies and the Qualified Income Offset
Limited liability companies (“LLC’s”) are now the most popular legal entities choice for most small businesses. They are formed in every state for business operations, estate planning, asset protection, property ownership, asset management, and for many other purposes. LLC’s are formed by sole proprietors, by families, by investment groups and by business operators There are two basic documents needed for the formation of an LLC, the Articles of Organization (or Certificate of Organization) and the Operating Agreement. One of the most desirable features of an LLC is the flexibility that LLC’s allow us in structuring the allocations of profits, losses and distributions to members in almost any manner that meets the desire of the members. An LLC may be taxed as a partnership, a C Corporation, an S corporation or a sole proprietorship as determined by the members. An LLC may provide for special and unique allocations of profits, loses, cash distributions and tax consequences among its members.
Because they are so flexible and because they allow a company to potentially operate under less formalistic rules, regulations and requirements than corporations, many clients are surprised that in many instances the costs of forming and structuring the LLC is greater than the costs of forming and structuring a corporation. An Operating Agreement may only be 8 or 10 pages long. However, it seems that most of my Operating Agreements range from 25 to 40 pages in length as they deal with such matters as management, membership, allocations, distributions and transfer restrictions. I have been involved in more than a few transactions in which the Operating Agreement was more than 100 pages long. You can imagine the cost and time involved in preparing an Operating Agreement that attempts to deal with the members’ business desires; as well as address a wide variety of contingencies. Frequently, the need for a complex Operating Agreement will result in a several lawyers involved in the drafting, reviewing and editing process.
Most LLC’s with more than one member elect to be taxed as partnerships and as a result, are subject to federal partnership tax laws and the partnership tax regulations adopted by the IRS. Many Operating Agreements contain provisions that deal with special allocations and other tax issues. These issues can be extremely complex and in some situations, neither the members of the LLC nor their lawyers have an adequate working knowledge of these issues.
If you read more than a few Operating Agreements you will often see certain defined terms such as Qualified Income Offset, Company Minimum Gain, Member Minimum Gain, Minimum Gain Chargeback, and Member Non-Recourse Debt. What do these terms mean? Why are these terms in so many Operating Agreements? How do they affect the members of the LLC? In this article we will provide brief and general information about the Qualified Income Offset. We will discuss other defined terms in future articles.
Qualified Income Offset
LLC’s taxed as partnerships must meet the “substantial economic effect” test of Treasury Reg. § 1.704-1(b)(2) for the allocation of income, losses and other items. If the Operating Agreement provides for allocations of profits and losses other than on a percentage membership basis, the allocations must have substantial economic effect or such allocations could be denied by the IRS. Allocations that are not based on an member’s percentage interests are referred to as “special allocations”. Therefore, if an LLC’s special allocations are deemed not to have substantial economic effect, they could be disallowed by the IRS.
The tax regulations provide two alternative tests for determining whether special allocations have substantial economic effect.
First Test. Under the first test, the Operating Agreement must unconditionally obligate all members with a negative capital account to restore the amount of such deficit balance to the LLC by the end of the taxable year during which liquidation occurs (or, if later, within 90 days after the date of such liquidation). Treas. Reg. § 1.704-1(b)(2)(ii)(b)(3). (Capital Accounts: Each member has a capital account which initially is the amount of capital the member invests in the Company. During the life of the LLC, the capital account is adjusted upward as income is allocated to the member and downward as losses are allocated to the member and as cash or other property distributions are made to the member. If a member has a positive capital account of $4,000 and then is allocated a $10,000 loss, such member has a negative capital account or deficit balance of $6,000).
One of the reasons business members select either corporations or LLC’s in which to operate their business is to have some protection from liability from creditors claims or from the claims of people injured by the business or the employees or agents of the business. If the Operating Agreement requires all members to repay capital account deficits upon the liquidation of the LLC, this could make the members liable to some degree for LLC debts. For obvious reasons, this is not an attractive option for complying with the substantial economic effect requirement.
Second Test. The alternate test for determining whether special allocations have substantial economic effect is generally more acceptable to LLC members than the first test. Under the second test, the LLC Operating Agreement will generally have substantial economic effect if it contains a “qualified income offset” provision. In general terms, a qualified income offset:
(i) prohibits the LLC from allocating losses from special allocations to an LLC member if it would increase the members capital account deficit (this means to take the capital account below -0-); and
(ii) requires the LLC to allocate income or gain to the member to eliminate any the negative capital account as quickly as possible.
The following are examples of a qualified income offset provisions that are sometimes contained in Operating Agreements:
• Those items of Company loss, deduction, or Code Section 705(a)(2)(B) expenditures which are attributable to Member Nonrecourse Debt for any Fiscal Year or other period shall be specially allocated to the Member who bears the economic risk of loss with respect to the Member Nonrecourse Debt to which such items are attributable in accordance with Regulations Section 1.704-2(i).
• To the extent a Member shall have a negative capital account balance, there shall be a qualified income offset, as set forth in Treasury Regulation 1.704-l(b)(2)(ii)(d).” I personally prefer more of an explanation of what the offset entails but I have seen no ruling for the IRS indicating that this phrase is inadequate.
• In the event any Member has a deficit capital account at the end of any Company fiscal year which is in excess of the sum of (i) the amount such Member is obligated to restore pursuant to any provision of this Agreement and (ii) the amount such Member is deemed to be obligated to restore pursuant to the penultimate sentences of Treasury Regulation Sections 1.704-2(g)(1)and 1.704-2(i)(5), each such Member shall be specially allocated items of Company income and gain in the amount of such excesses as quickly as possible.
If you want your special allocations to have substantial economic effect, your Operating Agreement should require members to restore a deficit balance in their capital account, or contain a qualified income offset provision.
This article is provided for general information purposes only and is not meant to be legal or other advice to any person or for any matter.
Contact A.O. “Bud” Headman at email@example.com for more information.
- On November 18, 2012