One of the advantages of operating a business as a partnership is the right to make special allocations of tax items among the partners. You have the same opportunity if you run your business as an LLC that’s treated as a partnership for federal tax purposes.
What Is a Special Tax Allocation?
A special tax allocation is an allocation of an item of partnership loss, deduction, income, or gain among the partners that’s disproportionate to the partners’ overall ownership interests.
The best measure of a partner’s overall ownership interest is the partner’s stated interest in partnership distributions and capital, as stated in the partnership agreement.
Example. An allocation of 80 percent of a partnership’s 2020 tax loss to Partner A, whose stated ownership is only 25 percent, is a special allocation of the tax loss.
After the partnership allocates its tax items among the partners, the allocated amounts (including any special allocations) are passed through to the partners on their annual Schedules K-1 received from the partnership.
Each partner then takes the passed-through amounts reported on Schedule K-1 into account on the partner’s federal income tax return (Form 1040 for an individual partner).
The partnership itself does not pay federal income tax. You and the other partners pay tax at the owner level. This is called pass-through taxation, because the tax consequences of the partnership’s activities are passed through to you and the other partners.
Key point. If you run your business as an S corporation, the pass-through taxation principle applies there too. But you’re not allowed to make special allocations of S corporation tax items among the shareholders.
Instead, you must allocate all tax items strictly in proportion to stock ownership. So, the ability to make special tax allocations is often a key selling point of partnership status as opposed to S corporation status.
How Special Tax Allocations Work
A partnership special tax allocation arrangement might work like this.
During the first few years of operation, when tax losses are expected, a disproportionately large percentage of the losses are specially allocated to the partners who need tax losses the most.
These may be the partners who supplied most of the initial capital, and they may be passive limited partners who are really just investors.
The other partners may be the ones who actually run the partnership’s business or investment activities, and they may be the general partners of a limited partnership. These partners are allocated a disproportionately small amount of the losses during the start-up phase when losses are expected.
In later years, the partnership is expected to generate positive taxable income and/or gains. Otherwise, the partnership was a bad idea to begin with.
The partnership will allocate a disproportionately large percentage of these later-year income and gain items to the partners who received earlier special allocations of losses. After these later-year special allocations of income and gain have offset the earlier special allocations of losses, all partnership tax items are allocated in proportion to the partners’ stated ownership percentages.
The special allocation phase of the partnership is over, and life goes on.
On a cradle-to-grave basis, you expect that all partners will receive cumulative allocations of taxable losses, deductions, income, and gain in proportion to their stated ownership percentages. So, the special allocations simply affect the timing of when you and the other partners recognize losses, deductions, income, and gain.
While the preceding description of a special allocation arrangement is often accurate, you can also have special allocations of specific tax items, such as depreciation, rather than special allocations of overall partnership losses.