Taxable Allocations of Income and Interests

April 13, 2006

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Strategic funding decisions when forming a business could have serious tax implications down the road when it comes time to allocate business interests and income.

To properly comply with these tax rules, the small business owner must be familiar with the different measures of the term "basis," and the effect these different measures have on the allocation of income among the owners of the business. Since tax law is particularly complicated, the owner should seek advice from a tax professional in these matters. However, owners should understand the basic rules governing tax basis.

When contributing non-cash property to a limited liability company (LLC), any difference between the property's fair market value and tax basis to the owner will require that the entity allocate depreciation, related to the item, away from the contributing owner and in favor of the other owners. The allocation of gain and loss from the sale of the asset will be to the contributing owner and away from the other owners.

The building contributed in the case study on tax implications of funding decisions would come under this rule. This allocation will usually mean less deprecation expense, but higher gain will be attributed to the transferor when the asset is sold by the business entity.

The critical concepts affecting the taxability of income and interest allocations are tax basis of the owner's equity interest, fair market value of the owner's equity interest and how the operating agreement dictates the division of profits.