The vast majority of business arrangements involve partners splitting profits and debts based on their contributions to the company. A two-person partnership, for example, often has a 50/50 split, but these arrangements can become more complicated as more partners are added.
For example, imagine a two-person partnership in which one partner contributed the majority of startup capital for the business. That partner might understandably not want to spend too long waiting for a return on the extra investment he or she made. In this scenario, a special allocation would help adjust for the disparity of investment.
What are special allocations?
A special allocation involves dividing profits and losses among all of the owners in ways that do not necessarily reflect the ownership interests of the members. Most of the time, there are perfectly legitimate reasons for wanting to create such an arrangement. However, there are situations in which partners will create a special allocation as a means to get around making some tax payments. Thus, the Virgin Islands Bureau of Internal Revenue (BIR) analyzes all special allocations before approving them, as the agency wants to make sure it is being established for valid business reasons.
In the event the BIR does choose to deny the special allocation, it will set taxes on the business members based on the proportion of the ownership interest held by those members.
Basically, the BIR wants to see a “substantial economic effect” on the business before it will be willing to approve a special allocation. A special allocation that does have a substantial economic effect will reflect its members’ economic situations, rather than a means of shifting tax responsibilities in a strategic manner.
Let’s say Bob and Christina start a company together. Bob has enough money to pay for startup costs, but Christina will have to make payments in installments. Christina could sign a contract stating she will pay for her portion over the next two years. The operating agreement for the company could then state that while both Bob and Christina maintain a 50/50 ownership split, Bob will receive 75 percent of the losses and profits during those first two years while Christina keeps making his payments.
In this scenario, the BIR will understand there is a substantial economic effect, as Bob currently has significantly more money invested in the company. While this is a rather simplistic example, it provides some insight into what the BIR looks to when examining special allocations.
For further information and guidance on special allocations and various other legal issues associated with business partnerships, speak with an experienced business and corporate law attorney and learn more about your options.
Steven K. Hardy is Chair of the BoltNagi Corporate, Tax and Estate Planning Practice Group at BoltNagi PC, a respected and experienced corporate planning law firm serving executives across the U.S. Virgin Islands.