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One of the remarkable features of an LLC is that partnership rules provide that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends are allocated according to percentage ownership.

For example, an LLC can provide 40 percent of the profits to a member who only contributed 20 percent of the initial capital. This is achieved by making what is called a special allocation.

To be accepted by the IRS, special allocations must have a “substantial economic effect.” In IRS lingo this means that the allocation must be based upon legitimate economic circumstances. An allocation cannot be used to simply reduce one owner’s tax obligations.

By including special language in your LLC’s operating agreement you may be able to create a safe harbor to insure that future special allocations will have a substantial economic effect. (As with ships at sea, a safe harbor for IRS purposes is a place of comfort and certainty.) The required language deals with the following:

1. Capital accounts, which represent the investment of the owner plus accumulated undistributed earnings, less accumulated losses, less any distribution of capital back to the owners. Each member’s capital account must be carried on the books under special rules set forth in the IRS regulations. Consult with your tax advisor on these rules. They are not unusual or out of the ordinary.

2. Liquidation based upon capital accounts. Upon dissolution of the LLC, distributions are to be made according to positive capital account balances.

3. Negative capital account paybacks. Any members with a negative capital account balance must return their account to a zero balance upon the sale or liquidation of the LLC, or when the owner sells his interest.

It should be noted that complying with the special allocation rules and qualifying under the safe harbor provisions is a complicated area of the law. Be sure to consult with an advisor who is qualified to assist you in this arena.