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 ๐ Also on YouTube at PlugAccountingandTax!
Tax Strategy for LPs - ๐ Looking in the Wrong Place
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You've decided to enter the wonderful world of private business and/or real estate investing. You send your CPA an email, being the proactive client you are, and let him know the wire is going out. But before you send the money, are there any tax-related things to be aware of? The CPAs response? "Nope - you're a passive investor, so not really much to do on your side." Or maybe you get ignored - 50/50 shot from what I hear. ๐คทโโ๏ธ But the right answer isn't actually that simple. It's just that you sent the CPA the wrong information and asked the wrong question. Instead of, "I'm sending this money," you need to say, "hey here is the offering memorandum (deck) and operating agreement of a deal I'm looking at investing in. How will this investment impact my tax plan?" And if you still get a "nope" or ignored - then todays email is for you โคต๏ธ What Sections Matter to InvestorsThe number one goal to maintain high trust with investors is avoiding surprises and setting expectations. We want to be able to predict income and losses coming from this investment - as those can and should be layered into the investors tax plan for the near and long-term. These are some of the sections I look at to help provide this feedback to LPs:
Tax DistributionsThis is the most frequent type of surprise. You get income allocated to you on your K1, but the investment needs the cash flow to grow or pay down other liabilities. It's also a mechanism that can protect money partners from squeezing out minority operating partners. Without this requirement, the GP can decide to hold all the cash based on their judgment. We don't like that. ๐ โโ๏ธ This section can go overboard though. Quarterly tax distributions can be onerous to maintain as it assumes a timely close of the books and payment of distributions based on income that may swing into losses in future quarters. But at least annual is the goal. Allocation Language and Capital StackThe pitch deck promises a cost segregation study will be done in year 1. Hell yea. Passive losses. ๐ฅณ But if you're an investor in a higher priority tier of equity, and the allocation language is "Target Capital," you may be in for a surprise. In Target Capital method of allocating losses, you work backwards through the priority of liquidation to assign losses. It makes sense because those lower classes of equity have higher economic risk of loss of their equity. It's a very different calculation from traditional safe harbor (the other common method of allocating income and loss) which usually goes more pro-rata sharing of losses. Friendly reminder - I offer paid Operating Agreement "audits". I'll review the operating agreement, offering memorandum (or similar), share feedback on tax impacts, and provide sample language. 90% of the operating agreements I review need help. Check out my landing page here or reply to this email. Preferred Returns - Income or DistributionsWhether your preferred return is taxed as interest income, or treated as a tax free return of capital depends on very specific language in the operating agreement. Where the preferred return is defined, if it is stated that it is payable without regard to income of the partnership - you have "guaranteed payments for the use of capital" - or GPFUC (couldn't have described it better ๐). Whereas if the preferred return is paid out of profits of the partnership, then you have a much easier case for return of capital or just a special allocation of income. Here's why GPFUC or normal distribution treatment matters. GPFUC is taxed as portfolio income (like interest). That means it's not passive income - and not eligible to be offset by passive losses. ๐ซข So investors can very easily have a mismatch when the K1 is showing losses on Box 1 or 2 while income on Box 4. The TakeawayIt's not just GPs that should pay me to read their operating agreements. ๐ซด LPs should also get their agreement they're investing into vetted for these and other red flags. Once the money is gone, you've lost a lot of leverage as an investor. But in all seriousness, the best tax strategies for LPs (and GPs) is usually done before the subscription doc is signed and capital account funded. It starts with understanding the tax impacts of the agreement and how that should set your expectations. ๐ซก Group Chat Worthy Posts ๐ฅ๐ฒ
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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 ๐ Also on YouTube at PlugAccountingandTax!
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