A happy LP can be your biggest advocate. But as much of the Twitter / X saw, angry LPs can also be a pretty big threat. And that spectrum is of happy / angry is all based on one thing: LP expectations. 🫴

How the LP expects the asset to perform 🏢, how they expect distributions 💵 to work, what they expect the K1 📄 to look like - all these impact their mood from month to month and year to year. Many of these things are conditional based on the market - but not all. To control what you can, lawyers and CPAs can work together to integrate these core documents to manage LP expectations:

1. Offering Memorandum (Deal Deck, or OM)
2. Operating Agreement (OA)
3. Tax Return and K1s

Let's break them down one by one. 👇

​

Offering Memorandum

The OM drives 80% of your LPs expectations. The other 20% of their expectations is from random internet articles 💻 or friends advice at weekend parties 🍖. So this is really your best shot at setting proper expectations. Primarily, this will drive their beliefs on:

1. What kind of equity is being raised - preferred returns being offered? How much is the GP co-investing? Is one class more at risk than another? 🍰
2. How the asset will perform over time - and when can they expect distributions and an exit event 🤷‍♂️
3. What kind of holding period will there be - a 2-3 year stabilization? Or a 10+ year hold with cash out refinance?
4. How will the GP / sponsor be compensated - management fees? Acquisition fees? Promote? 🤑

The question that the OM never talks about is what the K1 will look like for a given LP.

What usually happens is the GP uses very rough estimates of X% of total equity for an LP and then says like 30% of asset will be bonus depreciated, so year 1 your K1 will have$X in loss. But we all know that's as good as a blind throw at a dart board.

And while the LPs will hear from you more than just K1 time, it's a significant deliverable that a lot of expectations are built around.

​

Operating Agreement

The OA is where what was promised in the OM gets memorialized - and why the OA should be drafted with the OM right next to it. If the tax return doesn't match the OA, you can get sued for breach of contract. If it's because the OA doesn't match the OM, you can get sued for SEC violations. 🫤

And no one wants to get sued.

The OA is what controls:

1. How profits and losses are allocated - who gets losses first?
2. How cash is distributed - who gets cash first?
3. How the GP is compensated - usually a stated management fee, acquisition fee, and promote
4. How do refinances or recapitalizations happen - if new debt is needed, or new partners admitted (or exited) what that looks like

It controls more, but we're staying focused here on the tax impacts. 🤏

Big problems can occur when an LP has invested in a class of equity that sits in a more secure position in the deal but assumes equal participation in depreciation and losses. If the allocation language is bad, they can be in for a rude awakening.

You can also create phantom income 👻 for preferred returns being accrued even without distributions happening. And don't get me started on unforeseen promote crystallization impacts. 🔮

​

Tax Return and K1s

Preparing the tax return (and K1s that flow from it) is more of an art than a science. 🧪

You need to take into account the Operating Agreement, previous tax returns, and current year financial statements and cram them all into a template form that a few people will see all of and hundreds of people will see only partially. 😮‍💨

Let's pull together the above impacts in an example to illustrate how things can go sideways:

This is exactly why the OA has to reflect the OM and what the GP sold the LPs as to the mechanics of the deal. And this assumes the CPA actually requests, reads, and understands the OA - which is a rarity. 🙈

What happens in reality, when there's a disparity in how the LPs expect the tax return and how the OA calls for it, is the largest and loudest LP gets his way and agreements get amended. 📢

​

But all that drama can be saved on the front end with some general consulting and analysis - which also is a rarity. Which leaves it up the GP and well-informed LPs to address the issues up front before they become major headaches. 🤕

Together, the OM, OA, and K1s make up the mirepoix of partnership and real estate tax. 🥕🧅🫑

​

🫡

🔔 Reminder that I offer one-off consultations. $500 for up to an hour, or $1,500 for a full review of Operating Agreements and tax returns. Reply to this email to set up a call. 🔔

​

🚨🚨Have a Question - send a reply directly to this email and I'll answer it in upcoming emails 🚨🚨

Have an idea for a newsletter? Would love to hear from you. Want a deeper dive on anything above? Let me know!

Want to read previous issues? Click here.​

If you enjoyed this, please forward on to a friend and let me know on X / Twitter.