Lane and Cal each own 50 percent of the profits and capital of High Yield LLC. High Yield owns a portfolio of taxable bonds and municipal bonds, and each year the portfolio generates approximately $10,000 of taxable interest and $10,000 of tax- exempt interest. Lane's marginal tax rate is 35 percent while Cal's marginal tax rate is 15 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal want to modify their operating agreement to specially allocate all of the taxable interest to Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been allocated 50 percent of each type of interest income.
a. Is High Yield's proposed special allocation acceptable under current tax rules? Why or why not?
b. If the IRS ultimately disagrees with High Yield's special allocation, how will it likely reallocate the taxable and tax-exempt interest among the members?