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 👇 Also on YouTube at PlugAccountingandTax!
Operating Agreement Problems - a Peek 👀 Under the Hood
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Next week I'm flying out west to talk about Operating Agreements to a bunch of real estate GPs and investors at Reconvene. I could not be more excited to jam for even 45 minutes on a topic so near and dear to my heart. 🫶 Every year I read dozens of new operating agreements - and I see a handful of errors or tax misses that I'm going to share with that audience. But I didn't want to leave you guys out - so I have something exciting to share here. I've found a treasure trove of publicly available docs via EDGAR from funds that raise money under Reg A. And they show that even publicly filed docs are not immune from tax misses. So today we walk through one - a peek under the hood of an operating agreement review. ⤵️ Before we get into it, I'm not going to name and shame. Though the name of the fund, syndicator, and even attorneys are available. 😟 Miss #1 - Allocation of LossesWe start with a special call out section in the offering circular about how depreciation will be allocated - This is saying that depreciation will be allocated pro-rata based on percentage interests in the Company. Okay, so "percentage interest" isn't defined in the offering doc, so let's flip over to the OA to see if we can tell what will happen. Hmm. This seems to imply that membership interests includes 20% LPs and 80% GPs (manager units = Class M). That's a problem since Class M is a profits interest with no capital contribution. So they won't have any economic risk of loss to share in the losses. And what is the CPA going to do when they go to allocate loss? Look at the OA allocation language: That's Target Capital = meaning losses get shared between Class A and Class B first (not Class M). So not a great start. The CPA will be left to apply the Target Capital method (hopefully they know what that means) and ignore what was told to investors. Miss #2 - Preferred Returns as Return of CapitalPreferred returns are calculated similar to interest. They are a stated rate charged against unreturned capital contributions. For GPs looking to accelerate their path to promote - especially a promote as juice as this 80% deal - there are ways to accelerate that. We see them doing that here. Right under the distribution waterfall, we see this little gem. All distributions, including payment of pref, are counted as return of capital. Meaning, the pref is calculated against a shrinking base and then is later counted as preferred return. It's a slight of hand that isn't necessarily illegal. It's just using a different calculation method that something like a loan payment would not use. To their credit, however, this blurb was in the offering circular - so investors should have seen this and known before even making it to the OA and subscription docs. 📖 Miss #3 - Minimum Gain and ChargebackMinimum gain and minimum gain chargeback are tax terms that I always look for in OAs. They unlock the ability of LPs and GPs to use qualified nonrecourse debt to access losses via "at-risk" basis. So let's see what they put in th.... That's it. One paragraph and it only defines the chargeback component. This section is terrifyingly light. Usually the definitions I look for include:
The above section is the only place where "minimum gain" is included in the entire OA. And it only makes a glancing reference to the Regs that it's intended to implement. The TakeawayEven high-paid law firms that do this for a living are not beyond the reach of my love of reading operating agreements. If you enjoyed this deep dive, let me know - I will keep doing more if there's an appetite for them! And if you're in San Diego next week for Reconvene, reach out - would be great to see you there. 🫡 Group Chat Worthy Posts 🔥📲
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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 👇 Also on YouTube at PlugAccountingandTax!
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