Subject Line: Is Your LLC Operating Agreement Tax-Ready?
If you're involved in drafting or reviewing LLC operating agreements — especially for partnerships — it's not enough for the agreement to "look standard." Boilerplate language, if poorly worded or missing entirely, can create serious tax risks.
Here are a few key areas to focus on when reviewing an LLC or partnership agreement for tax integrity and IRS defensibility:
📌 Special Allocations: What Makes Them Stick
Partnerships have flexibility to specially allocate items like depreciation or income — but only if those allocations have Substantial Economic Effect (SEE). That means two things:
Economic Effect: A partner receiving a deduction must see an economic cost (e.g., lower liquidation value).
Substantiality: The allocations can’t be superficial or just aimed at short-term tax savings (e.g., shifting losses to a partner with expiring NOLs).
If SEE is lacking, the IRS can reallocate items regardless of what’s in the agreement.
✅ Safe Harbor Agreements: Your IRS-Friendly Option
The safest way to ensure special allocations hold up is to use a Safe Harbor Agreement — language the IRS has effectively pre-approved. There are three main types:
Basic: Includes capital account maintenance under §704(b), liquidation per positive capital accounts, and a Deficit Restoration Obligation (DRO).
Alternative: Swaps the DRO with a Qualified Income Offset (QIO) and includes minimum gain chargebacks and loss limitation language.
Economic Equivalence: A fallback approach when boilerplate is missing — but don’t rely on this unless you must.
Each version has technical requirements that must be spelled out in the agreement, and often they’re buried in the Definitions, Allocations, or Liquidation sections.
⚠️ The DRO vs. QIO Decision
A DRO obligates a partner to contribute cash to eliminate a capital account deficit after liquidation. It’s powerful but rarely used because of the open-ended liability.
A QIO is more common — it triggers a special income allocation to restore a capital account deficit, without requiring a cash contribution.
The QIO has its own quirks, including “unexpected event” language and timing mechanics that must be drafted precisely.
🍎 The "Apple Problem" — Allocated vs. Usable Losses
Even when a loss is properly allocated under §704(b), the partner must still clear other hurdles to deduct it:
§704(d) – Outside basis
§465 – At-risk rules
§469 – Passive activity loss limitations
An LLC member may “deserve” a loss on paper and still be unable to use it. It's critical to understand the interaction between internal allocations and individual tax treatment.
🔁 Section 704(c) and 754: Hidden Triggers
Some of the most overlooked tax provisions in operating agreements are those involving contributions of appreciated property or sales of partnership interests. These trigger the need for:
Section 704(c) tracking — to prevent gain shifting between members.
Section 754 elections — to allow basis step-ups for buyers or distributees.
Without this language, one partner’s gain could be duplicated, or worse, reallocated improperly.
🧮 Book-Ups, Step-Ups, and Revaluations
When new partners contribute capital or existing interests are sold, fair market value adjustments ("book-ups") to capital accounts may be appropriate. But these often create “reverse §704(c) gains,” which must be tracked separately — and that means your agreement needs built-in procedures to handle it.
🔍 TL;DR: Your LLC Agreement Should Do More Than Divide Profits
For your allocations to survive IRS scrutiny, your operating agreement needs to:
Maintain 704(b) capital accounts
Liquidate per capital account balances
Include DRO or QIO provisions
Address §704(c) and §754 elections
Include minimum gain chargeback and loss limitation rules
Specify how revaluations and curative allocations are handled
📄 If you’re unsure whether your agreement checks these boxes, I offer review services tailored for LLCs and real estate partnerships. Contact me to set up a review — before the IRS does it for you.