I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox π Also on YouTube at PlugAccountingandTax!
Intentional Operating Agreements + TargetCapitalAccount.com π
|
If you own a business with at least one other person, you have a document that governs how your business runs. Operating Agreement, Partnership Agreement, Shareholder Agreement - all driving the same things:
For too many small businesses and real estate GPs, the agreement comes from their attorney and the attorney focuses on the things they're good at - risk. And they avoid the things they're not good at - tax. That's where we come in. I recently spent a few hours reading a private placement memorandum and advising on the eventual operating agreement that would be derived from that. It is probably my favorite type of advisory work. So I wanted to share a few things I see repeatedly across the middle market of privately held business and real estate. Today will be targeted to partnerships, but S-Corps have equally important rules to follow. 1. Classes of EquityThis is an important step one. Each class usually gets different control rights and different returns on their investment. As a tax guy, I'm primarily focused on the latter. You want to be sure you have the right partners in the right classes based on their expected return. And that includes their expectation of post-tax impacts. Some LPs are tax agnostic and don't really care about things like depreciation. Others absolutely want the depreciation to offset other passive income they have. As well, if the promoted interest class will include some investors who are contributing capital and some who aren't (say a GP who is co-investing and then a key employee who is not), you want to split those classes up. Promote classes of equity are not taxable at grant because the IRS sees them as worthless. But if you get another partner in that same class of equity contributing capital for those same units, you have just disproven that important point. 2. Allocation LanguageA favorite topic of mine because it drives so much of what goes on the K-1s. If you have some partners who are less inclined to want depreciation, and others who want it more, using Target Capital Account allocation language and getting the right partners in the right classes of equity is how you get it done. The caveat is that the partner class that gets losses (from depreciation usually) allocated first also takes a lower priority on distribution rights. A tax-necessary trade off to make sure the economics of the business match the tax impacts. Alternatively, if all partners are expecting to participate pro-rata in losses you can just include the Safe Harbor allocation language and keep consistent priority of distribution rights. Too often, we have prepared returns based on executed agreements and had to answer questions from LPs about the difference in their expectations and what the K-1 shows. We have to prepare the returns based on the operating agreement and too many times off-the-shelf language doesn't reflect the intent of investors. 3. Fee WaiversOne strategy employed by GPs raising equity is to "waive" or "defer" the acquisition fee in lieu of profits interest on the exit. This is powerful for several reasons:
But it's easy to mess this up. When the agreement calls out that the sponsor is receiving additional promote instead of the acquisition fee, it becomes too easy for an IRS auditor to calculate a value at grant of the profits interest. Again, the profits interest is not taxable at grant because it's worthless. But if the agreement explicitly states the amount of the fee the sponsor is receiving at exit, it gets dicey. The promote needs to be uncertain - meaning it can't be in the money until certain return hurdles are met (IRR) on the other class of equity. So a good agreement will break these pieces up. The GP waives the fees. Period. π€ And then the GP gets promote. Period. π€ This accomplishes the same thing but in a safe way. The TakeawayIf you're raising equity from investors, make sure the tax language in the operating agreement jives with the intent across the deal. Out of the dozens of advisory engagements I've run for partnerships, not one agreement has been perfect. Making money is hard enough, don't leave the tax stuff up to the non-tax pros. π«‘ π Unpaid Promotion - If you enjoy reading tax war stories and lessons learned, check out a new newsletter being sent out by Diane Gilabert. She's a TaxTwitter OG and got a ton of experience in M&A tax. βhttps://gilabert-hopkins-llp-5bisob.subscribepage.io/β I remember the first time I was asked by a client to review an operating agreement for tax feedback some 10+ years ago. Zero idea what to look for. So I Ctrl+F'd "tax" and read whatever popped up. Sent the client an email two days later saying "looks good to me." But it started me down a path of what potential value is missing from not knowing what I was supposed to look for. A few months ago I vibecoded a site and published a handful of blogs all sourced from the 75+ pages I've written on this exact topic over the years. It's what I wish I would have had at my finger tips all those years ago. Yes, there are paid tools, but there is also a blog you can read all about operating agreements. If you want to support the work to spread the word on tax-aware operating agreements, look no further. TargetCapitalAccount.com Group Chat Worthy Posts π₯π²
Want to read previous issues? Click here.β Looking for the unsubscribe button? Before you do, just remember this is who you're unsubscribing to. If you leave, would love to hear feedback by replying directly to this email! |
The Plug [Newsletter]
I've been a CPA for nearly 20 years - serving private small business and real estate the entire time. I take the lessons learned in serving and now running a small business and share them here. For business owners, investors, and advisors looking to lower their cost of capital, subscribe for delivery straight to your inbox π Also on YouTube at PlugAccountingandTax!
Tax is hard. Making money doing taxes for others is even harder. That's usually the main driver for the mistakes I find on returns I look at for prospects. Most CPAs understand these basic things, like what we're talking about today - Basis, but they're trying to run a business. And quality is very difficult to scale. So how can you spot check the K1s you get (or prepare) on a partnership return? And what happens if you get it wrong? Glad you asked. π€ Why Basis Matters Basis in a partnership...
If you were charged penalty and interest for taxes at any point between January 2020 and July 2023, there is a chance the IRS over-assessed and owes you money back, at least for now. π A late-2025 federal court ruling held that the COVID-19 disaster declaration automatically postponed federal tax deadlines for that entire 42-month stretch, and any late-filing penalty, late-payment penalty, or underpayment interest the IRS computed using a "due date" inside that window is potentially...
Tax deferral β let's you compound savings at your business' internal ROI at the cost of the US Treasury. The biggest moves in the tax code work by delaying the tax due. Push the bill into the future and you keep using money the government would otherwise have. It's cheap capital. Hereβs the map on major deferral strategies across the lifecycle of a business: Stage 1: Starting the business When you put property into a new company in exchange for stock or partnership units, the tax code treats...