Taxes and Operating Agreements

Having the pain threshold to read an Operating Agreement (or LLC Agreement, or Partnership Agreement - same thing) is a powerful tool. But knowing what's missing from the agreement is where you can provide incredible value to your investors, clients, or yourself.

Today, we're going into one of my favorite topics - the Operating Agreement (OA)'s impact on the tax return. I'll cover some commonly misused terms, misapplied terms, and missing terms. 😵‍💫

Allocation Language

If you're read my stuff for long, you knew this was coming.

There are three types of allocation language that can be included in an OA for a partnership. And assuming it is followed by the preparer, can have significantly different impacts on the tax return and K1s. 🔀

• Safe Harbor Allocation Language - usually when losses are shared pro-rata on contributions and there is a promote for the sponsor.

  • Includes the following provisions in the OA:

    • Capital Account Maintenance 📝 - the sponsor tracks capital accounts for each partner

    • Deficit Restoration Obligation 🫴 - any partner who has a negative capital account will restore that account to $0 by paying it back to the partnership

      • Or Qualified Income Offset ⚖️ - no partner can go negative in their capital account if possible. And if they do, they are restored to $0 as fast as possible with special allocations

    • Liquidations in Accordance with Positive Capital Account Balances 🪣 - final distributions acknowledge capital account balances so no partner receives benefits without the corresponding income tax liability

• Target Capital Allocation Language 🎯 - usually when there are multiple classes of equity with layered "rights" to unreturned capital upon liquidation. Very common when you see "preferred returns." The give away for this language is the term "hypothetical liquidation at book value" or something similar.

• Partner's Interest in the Partnership - usually just a straight pro-rata sharing everything (income and losses) without a promote.

To know which type of language should be in the OA, you need to look at what investors or LPs were told - which would be in the Offering Memorandum or similar. What the LPs were promised should drive the OA language which in turn drives the tax returns and K1s.

When we inherit tax return work, probably 50-60% of them are done incorrectly - thus the offering above.

Preferred Return Language

This can be a nasty little surprise. 🪤

When the OA defines Preferred Returns, it may or may not make reference to available income of the partnership. In short, if the preferred return is paid out contingent on income of the partnership, that preferred return is usually treated as an allocation of income. Duh - but read on.

If, instead, the preferred return language has no regard for available income of the partnership then that preferred return distribution is likely a "guaranteed payment" to the receiving partner.

Guaranteed payments are deductions to the partnership (like interest expense) and are self-employment income to the receiving partner - creating a nasty little mismatch of income types. 😠

We see guaranteed payment treatment commonly done in larger deals with target capital allocations. But every OA should be read and sponsors warned before sending those K1s out - speaking from experience.

Profits Interest Safe Harbor

For my tax heads - Rev Proc 93-27. This is what gives some good safe harbor language for what the IRS will accept as profits interest. 🤝

For my non-tax heads - the beauty of a profits interest is that it's non-taxable when granted (hopefully). But if not done right, it can create a tax liability to the recipient as it's perceived as a grant of full participating equity.

The blurb that matters - the IRS will not treat a grant of a profits interest as taxable, except, "If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease."

The profits interest definition section in the OA could be helped along by explicitly covering this issue.

Minimum Gain and Chargeback

Partnerships that hold real estate subject to a mortgage should almost always have this language - it compliments qualified non-recourse debt to allow partners to technically go negative in their capital account. In layman's terms, that means the partner gets losses allocated to him (or distributions) in excess of his cash contributed WITHOUT paying taxes on it or being limited by basis. 🔻

Minimum Gain is like "pre-gain" that is the difference between the adjusted book basis (cost - depreciation) and the mortgage on that property. This pre-gain is allocated to partners under the premise that even if the property is handed over to the bank - the sales price would be the debt amount and the gain recognized would be the debt less the adjusted basis of the property given up. So partners get credit for that amount.

But this also requires chargeback rules - such that if debt is decreased in future years, the partners who have received this minimum gain allocation pick up income to not throw off the basis rules. ⏪

Deferred Acquisition Fees

An example helps illustrate this best 👇

GP and LP investors are buying a $1 million property ($300k equity, $700k debt)

GP is required to co-invest $30,000 - and LPs are contributing $270,000.

As a part of the purchase, GP is owed an "acquisition fee" of 3% of the property - or $30,000.

Under standard procedure, GP's S-Corp would pick up $30,000 of acquisition fee income and then GP would turn around and invest that same $30,000 into the property - trading income for an asset.

This creates tax inefficiency - especially at scale (10X or 30X those numbers). So we have previously advised other GPs to include a clause in the OA to allow them to grant approximately equivalent additional units of profits interest while foregoing the acquisition fee. This optionality does not harm the LPs and increases tax rate efficiency while deferring income recognition. 🏠

Tax Distributions

A lot of minority partners get squeezed out of positions by majority partners with this missing clause. Majority partners often can determine the distribution amounts (if at all) regardless of income allocated. So partners who are not in control can get left with a serious tax burden.

A tax distribution paragraph in the OA helps this situation by calling for distributions to be made at the highest marginal tax rates of the class of partners who have been allocated income.

Unreimbursed Partner Expenses

Unreimbursed Partner Expenses (UPE) are an especially useful tool at the partner level. UPE allows a partner to deduct against his K1 income, expenses related to that activity that have not been and will not be reimbursed.

For example:

• Mileage 🚗

• Out of pockets 🗃️

• Travel and lodging 🏨

The trick is that these types of expenses should be spelled out in the OA as not eligible for reimbursement - granting the partner the right to do so on their personal return against the income.

President Trump famously had something like $27 million of UPE that the IRS gave up on tracking down through various OAs so they just allowed the deductions. 🤦

Bonus Round - S-Corps

This is short and sweet. When you have an LLC agreement and convert to an S-Corp, you need to tighten up language to REMOVE partnership references, or language about capital accounts or non pro-rata distributions. 🙅‍♂️

It can turn your S-Corp to a C-Corp - which is a doomsday scenario.

Every year I read hundreds of OAs and enjoy doing so. Hope this helped spread the love of what I've learned so far.

And remember, if you need help analyzing your OA and returns - I'm here for you 🫂