My partner and I are in the process of updating our LLC Operating Agreement. Our attorney is recommending a provision requiring that book losses be allocated to member capital accounts AND that members must then make contributions to offset those negative entries. We don't want to require capital contributions from partners when we don't have a cashflow shortfall (only a book loss). He's stated that the provisions were drafted to comply with tax code. Does anyone else have experience with or recommendations on how to handle such a situation?
Here is something you might want to read:
DEFICIT RESTORATION OBLIGATIONS IN LLC OPERATING AGREEMENTS
It addresses some of the issues that people contemplating the use of (multi member) LLCs might want to consider.
People have abused the relatively flexible partnership allocation of the partnership items in order to shift income or loss from one partner to another in order to save taxes.
Thus, IRS has a framework that can reallocate the partnership items based on the “ partner's interest in the partnership” if IRS determines the method of sharing the partnership items lacks the “Substantial Economic effect” (SEE)
To meet the SEE, there are strict rules to maintain meaningful capital accounts including Deficit Makeup Requirement for those accounts.
With the requirement, the partner must at some point contribute sufficient capital to eliminate the deficit, and, that way, the partner has the burden of the loss that partnership has and the allocation of the partnership will be respected by the IRS because there is SEE.
This is a very high-level summary of the rules and is not comprehensive. there are many exceptions as well. Your lawyer is talking about that. It has to be in the place to have flexibility for the allocation of the income or loss.
Talk to your qualified professional.
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