Kristy Crabtree only knew that the real estate market was booming and that she needed money to get in on the action when she pitched the idea of a joint real estate venture to her grandfather. Her grandpa, the infamous “Swede” Milan Placko, disagreed. For forty years, Swede had invested wisely in real estate, so he was familiar with the subtleties of the tax code. He joined his granddaughter in business only after they explored their tax deduction options.
“I needed money, and my Grandpa wanted to reduce his taxes,” Kristy, a junior in college and majoring in political science at the time, says. I had no clue that owning real estate may help one’s tax situation.
DIVERSE ALLOTMENTS
Swede and other seasoned investors know that some property transactions require a more involved L.L.C. operating arrangement. The tax repercussions for investment are typically detailed in an L.L.C. agreement. Profits and losses are typically “split based on capital accounts” under L.L.C. agreements, and tax is paid on these sums. This agreement is generally acceptable because it is easy to understand and produces a fair outcome.
However, there are numerous cases where it makes more sense to divide income or expenses uniquely. Because he was at a higher tax rate, Swede gave all of the depreciation on the property he and his granddaughter bought to himself. Since Swede would be required to report the whole gain upon selling the property, Kristy approved the special allocation; the Internal Revenue Service also approved, despite Swede’s increased exposure to risk.
A Greater Exposure to Risk
Swede and Kristy met with his C.P.A. after assuming the IRS would recognize the special allocation. Swede’s analysis was validated by the C.P.A., which determined that the threshold for “substantial economic effect” had been reached. The C.P.A. went on to say that the individual who benefits from the special allocations is also the person who bears the economic burden and that this is the assumption upon which the term “substantial economic effect” is based.
“Substantial economic effect” is predicated on the same logic that leads individuals to shun special allocations. In the case of Kristy and Swede, for instance, Swede was taking on the lion’s share of the financial risk because he stood to lose more money if the real estate purchase fell through.
A VERY PRICEY TAX CUT?
The real estate deal that Kristy and Swede were involved in jeopardizes Swede. Swede put in $15,000, and Kristy put in $5,000 when they formed the L.L.C. Swede would ordinarily get 75% of all financial outcomes, including depreciation, whereas Kristy would get 25%. Nonetheless, Swede was now getting all the depreciation because of the special provisions in the L.L.C. operating agreement.
If the value of the investment property fell, Swede would be the one to bear the financial consequences. If the value of the $320,000 property dropped by 5% after three years and they were forced to sell for some reason, he estimated that the special allocation would cost him more than $6,000. Swede knew the tax savings from the particularly allotted depreciation would have been close to $2,300, but he still felt that $6,000 was too much to pay for such a small amount.
In contrast, Swede determined that he would have saved $2,300 in taxes if the property’s value had remained the same or increased. Having determined that it was doubtful he would be compelled to sell the property at a loss; Swede inserted the special depreciation allotment in the L.L.C. operating agreement.
WHAT HAPPENED
Swede and Kristy’s investment property is still in their possession three years later. While not all investors can say the same, these individuals are reaping the benefits of increased cash flow and favorable tax treatment. While Kristy is well on her way to being a wise real estate investor like her grandfather, Swede enjoys an annual tax benefit of $755 and has already purchased two more investment properties.
CONCLUDING REMARKS
Making sure that special allocations have a meaningful financial impact is a complex process that calls for the expertise of a lawyer and an accountant. However, if implemented, special allowances can significantly reduce your tax liability. The trick is to ensure that the member who enjoys the tax break also bears the financial cost of the change.
In addition, the CPA has some suggestions.
A clause in an LLC’s operating agreement always specifies how the company’s gains and losses will be distributed among the members. An L.L.C.’s profits and losses are typically divided among its members in proportion to their ownership stake in the business. The IRS will always honor this agreement, but it may not be in your best interest. Your limited liability company’s operating agreement should specify that your special allocations will have a “substantial economic effect.”
Significant Monetary Impact
Validating the “substantial economic effect” of special allocations is not often easy. Generally speaking, the criteria can be boiled down to two requirements: (1) the L.L.C. operating agreement must include particular articles, and (2) the special allocations must be based on economic reality.
There are 3 Conditions Necessary for “Economic Effect”
For your L.L.C. operating agreement’s special allocations to have an economic impact, you must include one or more of the following three clauses:
In other words, “Capital Accounts will be maintained following regulation 1.704-1(b)(2)(iv).” This is not a particularly onerous mandate; this rule is probably keeping your books.
Positive capital accounts will trigger dividends through the liquidation process. Another criterion that is easy to fulfill. This provision, customary in L.L.C. operating agreements, assures a fair liquidation.
There will be no liquidation until deficit capital accounts have been rectified. Caution is warranted because this provision is not typical and would likely be unacceptable in an L.L.C. operating agreement. This provision, however, can be replaced by the qualified income offset provision. Although qualifying payment offset provisions might get complicated, at their core, they are just a guarantee that surplus funds would be used first to restore deficit accounts. Members lose their protection from unlimited liability if they are required by their operating agreements to replenish their capital accounts perpetually.
Based on Real World Economics – “Substantiality”
Various tests can be used to determine whether or not a particular allocation is meaningful, many of which are highly subjective. The concept of “substantiality” is predicated on the idea that whoever receives the economic advantage of the special allocations also bears some of the financial burdens; hence testing for substantiality requires a comprehensive review of all tax allocations under the LLC operating agreement.
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