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flow expectations and the economics of individual member, by adding the
the underlying business deal. Unfortu- Despite the fact that income to the updated total capital
nately, however, the tax practitioner who for the entity from Step 3.
every LLC and its
needs to correctly allocate LLC income 5. Determine end-of-year cash waterfall
and loss pursuant to the terms of an op- related operating distribution priority under the terms
erating agreement that might be some- of the agreement (the distributions
what less than clear and straightforward agreement is that must be made when there are
is left alone to deal with the complexities unique, a process tiered partnerships in the entity
the target capital allocation structure structure), assuming a liquidation
creates. Gone are the days of simply for creating profit would occur at the end of the year.
multiplying an LLC owner’s percentage and loss allocations 6. Using the cash waterfall priority
share of units by the separately stated can be applied to (Step 5), allocate total entity capital
items of income/loss/deduction, etc. for (Step 4) among the partners to deter-
the purpose of populating the individual every partnership mine the end-of-year target capital
Schedules K-1, Partner’s Share of Income, with a target capital for each member. This step allocates
Deductions, Credits, etc. among the partners the total end-of-
Despite the fact that every LLC allocation structure. year capital they would be entitled to
and its related operating agreement is receive under the terms of the cash
unique, a process for creating profit and distribution provisions.
loss allocations can be applied to every applicable tax regulations. The 11 steps 7. Compare the target capital for each
partnership with a target capital alloca- are as follows: member from Step 6 to each mem-
tion structure. Not only will the use of a 1. Complete the federal taxable income ber’s preliminary capital from Step 3
consistent process improve a practitio- determination for the entity; i.e., to determine the correct allocation
ner’s overall quality, it also will enhance finalize the tax provision. of income/loss needed to achieve the
efforts to efficiently train young staff on 2. Adjust the federal taxable income desired capital account targets and
the process of creating LLC allocations from Step 1 to create what would create the necessary allocations for
in a manner that assures a quality prod- be referred to as Sec. 704(b) income. each member.
uct is produced and the risk of incorrect This represents profit/loss as defined 8. After the completion of Step 7, if any
allocations is minimized. in the agreement and must be used capital accounts have a deficit, ana-
Outlined below are 11 clearly de- for making allocations consistent lyze and/or calculate the correct ap-
lineated steps that must be followed with the terms outlined in the oper- plication of minimum gain principles
when creating tax allocations for a target ating agreement. Differences between to determine whether any such deficit
capital allocation structured partnership. income in Steps 1 and 2 typically capital accounts are proper. If not, the
It is important to note that these steps involve assets that have a gross asset income/loss allocations may need to
assume that proper Sec. 704(b) capital value for Sec. 704(b) purposes that be adjusted.
account maintenance rules are under- differs from tax basis, often referred 9. Make any Sec. 704(c) adjustments
taken and followed. This is consistent to as Sec. 704(c) differences. If such if needed to arrive at final tax
with the vast majority of agreements differences exist, it is imperative allocations.
that require capital account maintenance that Step 2 be clearly and separately 10. Determine the proportions of total
and limitations on deficit capital account completed because it will drive the (i.e., bottom-line) income allocations
balances and that also include a qualified remainder of the process. to allocate all separately stated items.
income offset provision. If proper capital 3. Update beginning-of-the-year Sec. Finalize Schedule K-1 details.
account maintenance is not being imple- 704(b) capital accounts for any con- 11. Complete the year-end tax basis and
mented (as required in the agreement), tributions, distributions, or ownership capital roll for each member based on
any allocations made under a target change activity that occurred during the final allocations.
capital allocation structure are problem- the year. This step creates a “prelimi- There are a few key components to
atic and cannot be assured of any level nary capital” amount for each mem- this process. First, the entire allocation
of accuracy. This leaves both the client/ ber as well as for the total entity. process is driven by the determination
taxpayer and the return preparer subject 4. Using the Sec. 704(b) income from and allocation of Sec. 704(b) income.
to the risks associated with not following Step 2, identify total end-of-year Sec. 704(c) allocations are driven by the
the dictates of the agreement and/or the capital for the full entity, not by Sec. 704(b) allocations and cannot be

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