CHAPTER 29B
DRAFTING CONTRACTUAL SPECIAL ALLOCATION
PROVISIONS IN THE OPERATING AGREEMENTS OF MULTIMEMBER LLCs TAXABLE AS PARTNERSHIPS
Table of Contents
28.01
28.02
28.03
28.04
INTRODUCTION ............................................................................................................................................... 1
[A]
The Purpose of This Chapter .............................................................................................................. 1
[B]
Definition of Special Allocations; Their Importance .......................................................................... 2
[C]
Types of Special Allocations ............................................................................................................... 3
CONTRACTUAL SPECIAL ALLOCATIONS—EXAMPLES .............................................................................. 3
[A]
Introduction……………… ..................................................................................................................... 3
[B]
Special Allocations of Partnership Start-up Losses .......................................................................... 4
[C]
Special Allocations of Partnership Initial Profits ............................................................................... 4
[D]
Special Allocation in the Form of Continuing Preferred Shares of Profits ....................................... 4
[E]
Limited Special Allocations of Preferred Share of Profits ................................................................. 4
[F]
Limitations on Total Allocations ......................................................................................................... 4
ENSURING THAT CONTRACTUAL SPECIAL ALLOCATIONS HAVE “ECONOMIC EFFECT” UNDER THE
SECTION 704(B) SAFE-HARBOR RULES ....................................................................................................... 5
[A]
Introduction…………. ........................................................................................................................... 5
[B]
The Three-Part Safe-Harbor Test for Achieving Economic Effect..................................................... 6
[C]
Capital Accounts………… .................................................................................................................... 7
[D]
Avoiding “Shifting Allocations” .......................................................................................................... 7
[E]
Avoiding “Transitory Allocations” ...................................................................................................... 8
PROFITS INTERESTS UNDER REVENUE PROCEDURES 93-27 AND 2001-43 ............................................. 8
[A]
Introduction…………… ........................................................................................................................ 8
[B]
Revenue Procedures 93-27 and 2001-43 ............................................................................................ 9
[C]
Profits Interest Drafting Issues ......................................................................................................... 10
_____________________________________________________________
28.01
[A]
INTRODUCTION
THE PURPOSE OF THIS CHAPTER
1) This chapter provide a brief, practical introduction to the partnership tax law
governing special allocations in the operating agreements of multi-member LLCs
CHAPTER 29B – Page 1
taxable as partnerships.1 The chapter is designed for lawyers who are not partnership
tax experts and who are generally unfamiliar with partnership special allocations.
2) Readers who wish a somewhat more detailed understanding of the above topic may
wish to consult partnership tax handbooks such as The Logic of Subchapter K by
Laura and Noel Cunningham or Federal Income Taxation of Partners and
Partnerships by Karen Burke.
3) Those who wish to understand the above topic in depth may wish to consult Klig and
Sloan, Bureau of National Affairs Tax Management Portfolio 720, Partnerships—
Taxable Income; Allocation of Distributive Shares; Capital Accounts or partnership
tax treatises such as Whitmire, Nelson, McKee, Kuller and Hallmark, Federal
Taxation of Partnerships and Partners or Willis, Pennell and Postlewaite,
Partnership Taxation.
[B]
DEFINITION OF SPECIAL ALLOCATIONS; THEIR IMPORTANCE
Special allocations are allocations by a partnership to its partners in its partnership
agreement of partnership income, gain, loss, deductions, credits and other partnership tax
items in a manner that is disproportionate to the partners’ respective shares of aggregate
contributions. (As readers will recall, a partnership’s allocations of tax items to its
partners means its accrual of these items to these partners on its books. Partnership
distributions mean actual transfers of partnership cash or other property to the members.
Under most partnership agreements, the amount of cash and the fair market value of
property distributed by a partnership to a partner cannot exceed the dollar value of
allocations to the partner.)
As further discussed below, special allocations may be either “regulatory” or contractual.
Below in italics is an example of a contractual special allocation. (Additional examples
are provided in § 29B.02 of this chapter.)
Individuals A and B are partners in AB Partnership. Each of them contributes
$100,000 in cash to AB. AB’s partnership agreement provides that AB shall
allocate 60% of its profits to A and 40% to B.
Contractual special allocations can provide partnerships with powerful tools to attract and
reward talent and investment. State-law business corporations taxable as C corporations
can issue preferred classes of stock that roughly equate to partnership special allocations,
but Subchapter C is a double tax regimen and its capital structure must be disclosed
publicly in its articles of incorporation. Partnerships are pass-through entities and their
capital structures are private. Because of the Subchapter S single-class-of-stock rule,
state-law business corporations taxable as S corporations may not provide their
shareholders either with preferred stock or with special allocations in any other form.
All references in this chapter to “partnerships” are to multi-member LLCs taxable as
partnerships, and all references to “partnership agreements” are to the operating agreements of
multi-member LLCs taxable as partnerships.
1
CHAPTER 29B – Page 2
[C]
TYPES OF SPECIAL ALLOCATIONS
There are several distinct types of special allocations that the IRC and the U.S. Treasury
regulations under Section 704(b) (the “Section 704(b) Regulations”) require partnerships
to provide for in their partnership agreements. Tax practitioners often refer to these
special allocations as “regulatory allocations.”

Regulatory allocations include, for example, mandatory special allocations under
IRC § 704(c)(1)(A) of partnership gains and losses on partnership dispositions of
contributed property to the partners who have contributed that property.

They include mandatory provisions specially allocating to the partners partnership
deductions in respect of “nonrecourse property.” Nonrecourse property is
property, such as mortgaged real estate, whose purchase the partnership has
financed in borrowings in which the only collateral is the property itself.
Deductions in respect of such property, referred to as “nonrecourse deductions,”
include, for example, interest and depreciation deductions.

They include mandatory provisions specially allocating increases in “partnership
minimum gain” to the partners. “Minimum gain” is the amount by which the
non-recourse debt with respect to partnership property exceeds the sum of the
partnership’s adjusted basis in the property plus distributions that are made from
non-recourse debt proceeds. Increases in this “minimum gain” will occur, for
example, when the partnership pays down a mortgage loan on partnership real
property.
However, in addition to regulatory allocations, which partnerships must provide for in
their partnership agreements, partnerships may provide in their partnership agreements
for contractual special allocations to their partners. These contractual special allocations,
the terms of which, as the name implies, are negotiated among the partnerships, generally
may be accrued by a partnership in its books only after it has accrued all regulatory
allocations to which it is subject.
Allocations of partnership tax items not allocated by regulatory or contractual allocations
are sometimes referred to by tax practitioners as “residual” allocations.
28.02
[A]
CONTRACTUAL SPECIAL ALLOCATIONS—EXAMPLES
INTRODUCTION
As discussed further in § 28.03 of this chapter, a contractual special allocation whose
principal purpose is to avoid federal income taxes is unlikely to survive scrutiny in an
IRS audit. 2 However, there is a vast range of economically motivated contractual special
However, it is often possible by careful planning and drafting to specially allocate particular tax items to
particular partners in situations in which these allocations have at least a significant, if not a principal, tax
avoidance motive. For this reason, it is sometime appropriate in connection with the negotiation of the
allocation provisions of a partnership agreement to ascertain the specific federal income tax profiles of the
prospective partnerships in order to determine whether the above drafting may be appropriate for one or
more of them.
2
CHAPTER 29B – Page 3
allocations available to partnerships, and all of these special allocations are likely to be
respected by the IRS. The following are several hypothetical situations that illustrate
what, in my experience, are among the most common types of economically motivated
contractual special allocations. The special class of contractual allocations known as
profits interests is discussed in § 29B.04 of this chapter.
As you will see, the basic facts in each of the hypothetical situations below are the same.
However, for clarity, I will repeat them in each situation.
[B]
SPECIAL ALLOCATIONS OF PARTNERSHIP START-UP LOSSES
Individual A forms AB to manufacture and sell widgets. A contributes $100,000 to AB.
Individual B, a wealthy friend of A, is willing to contribute an additional $100,000.
However, in exchange for this investment, B requires that AB’s partnership agreement
provide that the first $100,000 of AB’s losses must be allocated to B. Any additional
losses will be allocated to A and B in accordance with their respective capital accounts.
(The meaning of “capital account” for partnership tax purposes is discussed in § 28.03[C]
of this chapter.)
[C]
SPECIAL ALLOCATIONS OF PARTNERSHIP INITIAL PROFITS
Individual A forms AB to manufacture and sell widgets. A contributes $100,000 to AB.
Individual B, a wealthy friend of A, is willing to contribute an additional $100,000.
However, in exchange for this investment, B requires that AB’s partnership agreement
provide that the first $100,000 of AB’s profits be allocated to B and that the first
$100,000 that AB distributes be distributed to B.
[D]
PERMANENT SPECIAL ALLOCATIONS OF PREFERRED SHARES OF PROFITS
Individual A forms AB to manufacture and sell widgets. A contributes $100,000 to AB.
Individual B, a wealthy friend of A, is willing to contribute an additional $100,000.
However, in exchange for this investment, B requires that AB’s partnership agreement
provide that, in each of its taxable years through its existence, AB will allocate 40% of its
profits to A and 60% to B.
[E]
SHORT-TERM SPECIAL ALLOCATIONS OF PREFERRED SHARES OF PROFITS
Individual A forms AB to manufacture and sell widgets. A contributes $100,000 to AB.
Individual B, a wealthy friend of A, is willing to contribute an additional $100,000.
However, in exchange for this investment, B requires that AB’s partnership agreement
provide that AB allocate 40% of its profits to A and 60% to B until B has received
distributions totaling $100,000. Thereafter, AB’s partnership agreement will provide for
equal distributions to A and B.
[F]
LIMITATIONS ON TOTAL ALLOCATIONS
Individual A forms AB to manufacture and sell widgets. A contributes $100,000 to AB.
Individual B, a wealthy friend of A, is willing to contribute an additional $100,000.
CHAPTER 29B – Page 4
However, in exchange for this investment, B requires that AB’s partnership agreement
provide that B will receive a special allocation of the first $100,000 of A’s profits
followed by an additional $100,000 as a return of B’s capital contribution. AB’s
partnership agreement will provide that thereafter:

B’s partnership in AB will terminate; and

All allocations of AB profits and losses and all distributions by AB will be made
exclusively to A.
28.03
[A]
ENSURING THAT CONTRACTUAL SPECIAL ALLOCATIONS
HAVE “ECONOMIC EFFECT” UNDER THE SECTION 704(B) SAFEHARBOR RULES
INTRODUCTION
The most basic policy underlying Subchapter K is that, except to the extent otherwise
permitted under specific provisions of the IRC, allocations of partnership tax items in
partnership agreements will not be respected for federal income tax purposes if their
principal purpose is tax avoidance. In other words, under this policy:

Partners must pay federal income tax on the dollar value of any economic income
or gain they realize from their partnership; and

Partners may not use partnership losses for federal income tax purposes—e.g., to
offset non-partnership income—unless they bear the economic burden of these
losses.
The principal section of Subchapter K governing the sharing of income, gain, losses,
deductions credits and other tax items among the partners of a partnership is Section 704,
entitled “Partner’s Distributive Share.”

Section 704(a) provides, in essence, that the partners of a partnership may
determine by contract how their partnership’s tax items shall be shared among
them. The terms of Section 704(a) are as follows (in italics):
(a) Effect of partnership agreement
A partner’s distributive share of income, gain, loss, deduction, or credit
shall, except as otherwise provided in this chapter, be determined by the
partnership agreement.

However, Section 704(b) sets forth a major qualification to the general rule of
contractual freedom in Section 704(a). Section 704(b) provides as follows (in
italics):
(b) Determination of distributive share
A partner’s distributive share of income, gain, loss, deduction, or credit
(or item thereof) shall be determined in accordance with the partner’s
interest in the partnership (determined by taking into account all facts and
circumstances), if—
CHAPTER 29B – Page 5
(1) the partnership agreement does not provide as to the partner’s
distributive share of income, gain, loss, deduction, or credit (or
item thereof), or
(2) the allocation to a partner under the agreement of income,
gain, loss, deduction, or credit (or item thereof) does not have
substantial economic effect.
Under Section 704(b)(2), the IRS may ignore special allocations of partnership tax items
set forth in a partnership agreement and may reallocate these items in accordance with the
“partners’ interest in the partnership” unless these allocations have “substantial economic
effect.” In general, the requirement of “substantial economic effect” under Section
704(b)(2) simply reflects the above principle that tax must reflect economics.
The Section 704(b) Regs provide various tests for determining in various situations
whether particular allocations will be treated as having a substantial economic effect.
However, for the great majority of partnerships whose partnership agreements provide for
contractual special allocations:
[B]

The partners may be confident that these allocations will be treated as having
economic effect within the meaning of Section 704(b) if their partnership
agreement contains the three safe-harbor provisions described in § 28.03(B]..

They may be confident that each such allocation will be treated as having
substantial economic effect if the allocation is not a “shifting allocation” or a
“transitory allocation” (as defined in § 28.03[D] and [E]).
THE THREE-PART SAFE-HARBOR TEST FOR ACHIEVING ECONOMIC EFFECT
In order for the contractual special allocations in a partnership agreement to be deemed to
have “economic effect” under the above three-part test, the Section 704(b) Regs provide
as follows:
1) The partnership agreement must require the partnership to maintain capital accounts
for each of the partners in accordance with the capital account maintenance
requirements of Regs. 704-1(b)(2)(iv)(b), and the partnership must maintain these
accounts in accordance with these rules throughout the life of the partnership.
2) The partnership agreement must require that the partnership make liquidating
distributions to the partners in accordance with these capital accounts. Under Regs §
1.701-1(b)(2)(ii)(g), the term “liquidation” includes the liquidation of thee partnership
itself and the liquidation of the partnership interest of each partner.
3) Under the partnership agreement:
a) Each partner must agree, in connection with the partnership’s liquidation, to
restore any deficit in the partner’s capital account in connection with the
liquidation of the partnership or of the partner’s partnership interest; or,
alternatively,
b) Each partner must agree that, if any such deficit unexpectedly arises because of a
loss allocated to the partner in a given taxable year, the deficit will be offset as
CHAPTER 29B – Page 6
soon as possible by a special allocation of income to that partner under a
“qualified income offset” provision (a “QIO” provision).
[C]
CAPITAL ACCOUNTS
The broad purpose of the capital account requirements of the Section 704(b) Regs is to
implement the above “economics trumps tax” policy of Subchapter K. In essence, the
capital account provisions of the Section 704(b) Regs determine, on economic grounds,
the current share of each partnership of a partnership in the economic net value
(effectively, the equity) of the partnership.
Under Section 1.704-1(b)2)(iv)(b) of the Section 704(b) Regs, a partners' capital account
will be determined to be maintained in accordance with the Section 704(b) Regs only if,
with certain narrow exceptions set forth in these regs, the partner's capital account :
a) Is increased by:
i) The amount of money contributed by the partner to the partnership;
ii) The fair market value of property contributed by the partner to the partnership
(net of liabilities that the partnership is considered to assume or take subject
to); and
iii) Allocations to the partner of partnership income and gain, including income
and gain exempt from tax; and
b) Is decreased by:
i) The amount of money distributed to the partner by the partnership;
ii) The fair market value of property distributed to the partner by the partnership
(net of liabilities that the partner is considered to assume or take subject to);
iii) Allocations to the partner of expenditures of the partnership described in IRC
Section 705 (a)(2)(B) (comprising “expenditures of the partnership not
deductible in computing its taxable income and not properly chargeable to
capital account; and
iv) Allocations of partnership loss and deduction.
[D]
AVOIDING “SHIFTING ALLOCATIONS”
A shifting allocation within the meaning of the § 704(b) Regs is an allocation that
reduces the partners’ total tax liabilities for a particular taxable year without substantially
affecting the partners’ capital account balances for that year. As stated in Cunningham
and Cunningham, The Logic of Subchapter K, at page 137:
“Under the § 704(b) regulations, a shifting allocation is not substantial if, at the
time the allocation becomes part of the partnership agreement, there is a ‘strong
likelihood’ that the net increases and decreases in the tax structure’ capital
accounts for the year ‘will not differ substantially’ from the net increases and
decreased that would occur without the allocation and the total federal income tax
liability of the partners will be reduced as a result of the allocation.”
CHAPTER 29B – Page 7
For example, if, for a given taxable year, a partnership allocates specified taxable income
to a low-bracket partner and an equal amount of tax-exempt income to a high-bracket, the
IRS may well treat these allocations as “shifting allocations” and reallocate the income in
question among the partners.
[E]
AVOIDING “TRANSITORY ALLOCATIONS”
As explained in Cunningham and Cunningham, The Logic of Subchapter K at page 139:
“A transitory allocation is similar to a shifting allocation, except that the effect of
the original allocation on a partner’s capital account [in a particular taxable year]
is neutralized by an offsetting allocation in a subsequent year rather than in the
same year.”
To illustrate: In an equal two-person partnership, one partner has a net operating loss due
to expire in the current taxable year. The partnership allocates the partnership’s income
for the current year to that partner to enable the partner to use these losses, and it
allocates partnership income in subsequent years to the other partner until the original
allocation is offset.
28.04
[A]
PROFITS INTERESTS UNDER REVENUE PROCEDURES 93-27 AND
2001-43
INTRODUCTION3
A profits interest (also often called a “carried interest”) is an interest in partnership profits
granted by a partnership to a recipient under its partnership agreement not in exchange
for any capital contribution by the recipient, but rather, in exchange solely for the
recipient’s past services to the partnership or the recipient’s promise of future services to
it.
Although there are many important federal income tax differences between profits
interests and corporate stock options, profits interests function for many partnerships in
somewhat the same manner as stock options function for corporations. Because, by
definition, a profits interest is an interest in partnership profits that is not proportionate to
the holder’s share of aggregate contributions to the partnership, it is a form of special
allocation.
Profits interests can be powerful tools for partnerships in rewarding partners and other
persons for past services to the partnership and in attracting potential partners to become
partners. For these reasons, profits interests are, for many partnerships, including even
relatively small ones, the most important type of special allocation. In effect, a profits
This section of Chapter 29B is based in part on Hines, Taking Advantage of the “Carried Interest
Loophole,” New Hampshire Bar News, February 19, 2014; and on Banoff and Sloan, Bloomberg Law, The
Partnership Tax Practice Series, 2013, Rev. Proc. 2001-43, Section 83(b) and Unvested Profits Interests—
The Final Facet of Diamond?). Obviously, however, I alone am responsible for any errors in the section.
3
CHAPTER 29B – Page 8
interest gives its recipient free-of-charge a potentially significant stake in the success of
the partnership that grants it.
[B]
REVENUE PROCEDURES 93-27 AND 2001-43
The chief IRS authority concerning profits interests is an IRS administrative ruling
designated Revenue Procedure 93-27. Rev. Proc. 93-27 defines profits interests on the
basis of its definition of capital interests.

It defines a capital interest in a partnership as “an interest that would give the
holder a share of the proceeds if the partnership’s assets were sold at fair market
value and then the proceeds [of the sale] were distributed in a complete
liquidation of the partnership. [The determination of whether an interest is a
capital interest] generally is made at the time of receipt of the partnership
interest.”

It defines a profits interest as “a partnership interest other than a capital
interest”—in other words, an interest that would not give its holder share of the
above proceeds.
Section 721 of the IRC provides that contributions of cash and property by a partner to a
partnership do not trigger federal income taxes to either the partnership or to the partner.
However, under Regs § 1.721-1(b)(1), the receipt by a partner of a partnership capital
interest for services to or for the partnership is taxable as compensation. But, as indicated
above, Rev. Proc. 93-27 provides that the receipt of a profits interest for services will not
trigger federal income tax for the recipient or the partnership unless:

“The profits interest relates to a substantially certain and predictable stream of
income from partnership assets, such as income from high-quality debt securities
or a high-quality net lease”; or

“Within two years of receipt [of the profits interest], the partner disposes of the
profits interest”; or

“The profits interest is a limited partnership interest in a publicly traded
partnership within the meaning of section 7704(b) of the [IRC].”
In addition, an IRS administrative ruling designated Rev. Proc. 2001-43 provides, in
effect, that a partnership’s grant of an unvested profits interest to a service provider will
not trigger federal income tax to the partnership or the recipient either in the year of the
grant or in the year of the vesting as long as:

The profits interest meets the requirements for tax-free treatment set forth in Rev.
Proc. 93-27;

The partnership and the recipient treat the recipient as the owner of the
partnership interest from the date of its grant; and

The recipient takes into account her distributive share of partnership tax items in
each relevant taxable year in determining her federal income tax liability.
CHAPTER 29B – Page 9
The holder of a profits interest reports her share of partnership profits in her individual
federal income tax return. The “character” of these profits—i.e., as ordinary income or
capital gains—is the same in the hands of the holder as in the hands of the partnership.
Recipients of profits interests can realize significant current income from their shares of
the partnership’s profits if the partnership is successful. But for many of these recipients,
by far the greatest economic benefit of a profits interest may come if the partnership is
eventually sold.
Although the matter is not without doubt, there is solid authority for the position that a
partnership may grant both a profits interest and a capital interest to a person in exchange
for past or future services to or for the partnership. As indicated above, the grant of the
capital interest will be subject to federal income tax in the hands of the grantee and will
be deductible by the partnership. As indicated above, the grant of the profits interest will
be subject to federal income tax neither to the grantee nor to the grantor. See generally,
Banoff and Sloan, Bloomberg Law, The Partnership Tax Practice Series, 2013, Rev.
Proc. 2001-43, Section 83(b) and Unvested Profits Interests—The Final Facet of
Diamond? (“Banoff and Sloan”) at page 31-30 et seq. However, the partnership should
make sure that it separately and comprehensively documents in its partnership agreement
the separate features of both of the capital and the profits interest in question.
[C]
PROFITS INTEREST DRAFTING ISSUES
In many cases, drafting the basic terms of a profits interest in a partnership agreement can
be relatively simple and will not require specialized partnership tax expertise. To
illustrate:

AB is a multi-member LLC taxable as a partnership. Its members are individuals
A, an investor, and B, a highly skilled manager. AB is not a publicly traded
partnership. On the date of AB’s formation, A contributes $100,000 in cash to AB
in exchange for a capital interest that entitles him to a 75% interest in AB’s
profits. B makes no contribution of cash or property to AB, but AB’s partnership
agreement provides that, effective on the date of AB’s formation, B will be entitled
to 25% of AB’s profits. On that date, it is uncertain whether AB will ever be
profitable,

AB’s partnership agreement also provides that B may not dispose of her profits
interest until two years after its grant, and it provides that if, on the date of the
grant, AB were to be liquidated, B would be entitled to none of the proceeds of the
liquidation.
Under the above terms, the partnership interest granted by AB to B is a profits interest
within the meaning of Rev. Proc. 93-27, and its grant by AB to B triggers no federal
income tax to either AB or to B.
However, when a partnership grants a profits interest to a person for future services, it
will generally want to provide either:

That the profits interest will not vest with the recipient until a stated date or until
the recipient achieves one or more specified objectives; or
CHAPTER 29B – Page 10

That although the profits interest will vest on grant, the recipient must forfeit it
upon the occurrence of stated conditions.
In the above circumstances:

Many recipients of unvested profits interests may want to file an election under
IRC Section 83(b) to lock in their tax-free treatment in respect of this profits
interest. However, before they do so, they should consult with their tax adviser to
ensure that this election will not have any adverse federal income tax effect on
them. See generally, Banoff and Sloan, page 31-34 et seq.

A partnership should consult its tax adviser as to issues relating to built-in gain or
loss in the partnership’s assets at the time of the grant of a profits interest and
from the date of the grant to the date of vesting. To address these issues, the
partnership may want to revalue up its assets to their current fair market value as
of the date of the grant or vesting or, as of that date, to specially allocate built-in
gains and losses to the vested partners as of these dates. See generally, Banoff
and Sloan, page 31-23 et seq.
Finally, the tax advisers of a partnership granting a profits interest to a recipient that is
subject to forfeiture and the tax advisers of the recipient should advise their clients at the
time of the grant concerning the federal income tax consequences for the partnership and
the recipient in the event of a forfeiture.
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