The Plug: a newsletter for business owners, accountants, and everyone in between

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Being a part owner of a business can be a lifelong goal realized for many people. You dream 🛌 of being a partner, shareholder, or co-founder and when the day comes it can feel surreal. 👑

But for too many of those who make it there for the first time, the business operating agreement (OA) can be a source of uncertainty. 🤷‍♂️ Tossed in the drawer 🗄️ as a "check-the-box" document that was half-read and a quarter-understood.

To make things worse, many attorneys will draft boiler plate provisions and kick 🦵 the can to the "CPA" to review the tax parts of the OA - the proverbial buck pass. And most CPAs are not experts in OA language. Which is terrifying 👻 because of the implications the OA language has on the actual business and tax filing cannot be understated.

When the Tax Court looks at the legitimacy of the business decisions, it usually starts with the OA before going to case law. Only if the OA is lacking will they look at precedent or other external inputs. But first and foremost stands the OA for all things business and tax.⚖️

Rant over - let's look at some basic tax parts of the Operating Agreement and how they affect you 👇:

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Terminology

Most OAs will start with key terms defined. It sounds simple, but you should read these, understand them, and understand where they fit into the agreement. Here are the major ones:

• Capital Account 📒 - you'll expect to see this one in a partnership for federal tax purposes (think real estate). You would never want to see this one in a S-Corp for federal tax purposes (think single member LLC) 🙅‍♂️. Capital account maintenance is a critical part of partnership tax compliance but can imply a busted S-Election for S-Corps.
• Classes of Units - the definitions section will also likely be where your preferred return (if you have them) is defined. You want to be sure the preferred returns (pref) only apply to the correct class of units and not everyone (if that's the plan). 🤓 You'll also want to confirm when pref is accrued, paid, and how it's classified. Terms like guaranteed payment and references to IRC §707(c) usually indicate a tax treatment more akin to interest rather than distributions.
• Deficit Restoration Obligation - this is a mechanism specific to partnerships that allows a partner with less than pro-rata capital to receive loss allocations in excess of their capital contributions. 🏦 It is a real obligation to payback in cash the loss allocated to them below their capital account. This can be a great planning tool for the properties that will be slam dunks 🏀. But there can't be conditions attached to it for it to be valid.

Allocations

I love this part of OAs 🥰. Tax allocation language for S-Corps is simple because you have to keep distributions pro-rata to not violate the "single class of stock" rule of S-Corps.

But not so with partnerships - they are the most flexible 🧘‍♂️ when it comes to allocating income. And the variation in language reflects this flexibility, to a nearly disgusting extent.

You can group the types of partnership allocations into two ✌️ primary types - with variations within each:

1) Percentage Interest or Safe Harbor - this is the "pro-rata" method that you will see in S-Corps and very vanilla partnerships. The wrinkle to partnerships will be if there is a promote layered in - in which case you'll need to include Safe Harbor language. 📖

Safe Harbor language for partnerships includes three key definitions and clauses: (1) Capital Account Maintenance, (2) Deficit Restoration Obligation, or Qualified Income Offset, and (3) Liquidating Distributions in Accordance with Positive Capital Accounts. I won't take a deep dive 🤿 on these (if you want to check my X highlights tab, or I have a 5 part email series I can send you) but they're critical to having and performing to keep the promote respected.

2) Target Capital - 🎯 this the method you typically see when you have varying types of classes of units in a partnership. THIS IS NOT ANYTHING YOU EVER WANT TO SEE IN A S-CORP OA. 🙅‍♂️

Target capital method effectively works to calculate how much of the ending balance sheet would go to which partners, and then allocate income or losses between them to arrive at that ending "capital account."

Let's work through an "easy" example. 😉

Add in a few years of activity, new partners entering and old partners exiting, and this calculation worksheet can get beefy. 🐄

The key words you're looking for to know if you have target capital account allocation language is "hypothetical liquidation" in the allocation section. You also need to be very explicit which distribution schedule that is used to calculate the ending target capital - as there can be different waterfall distribution schedules for different events (refinance, recapitalization, liquidation). 😵‍💫

Distributions

Speaking of distribution schedules, these sections are critical to nail down in the OA.

The "Waterfall" 🏞️ is the term used to refer to the ordering of distributions between different classes of units or equity. I won't go ALL CAPS on you again, but remember that you should not see a waterfall distribution schedule in a S-Corp OA - that would be a violation of the single-class of stock rules and wind you up with a C-Corp. 🙅‍♂️

In addition to the different types of layering for different types of events (refinance, recap., liquidation), the language used to describe the preferred return should also be paid attention to. Under IRC §707(c), payments made to partners that are not strictly based on the income of the partnership but rather mirror a pseudo-interest payment will be classified as a guaranteed payment. A guaranteed payment can result in an income tax classification by that partner. 🤝

A well-written tax distribution section can avoid a bigger fight down the road over the thing most dreaded in pass-through businesses: Phantom Income. 😱 A tax distribution section will contemplate the income allocated to each partner and assign a set tax rate of required distributions so no partner gets shafted having to pay tax on income allocated to them that they did not receive.

Lastly, worth noting that this tax distribution usually overrides the distribution waterfall, so may actually delay preferred return or higher classes of units from receiving their return of equity. 👴🏻

Profits Interests Language

Profits interests are a great tax planning tool to incentive partners in a partnership.

The represent an interest in the upside ⬆️ of the underlying entity and are accomplished through special allocations of income and/or gain. Side note - they only represent a participation in the underlying character of the income or gain. Meaning, if the profits interest goes into effect with ordinary income, the profits interest holder will receive an allocation of ordinary income on his K1. I see many times people assuming that just because the income is coming to them via a profits interest that it is default capital gain. 👌

The IRS acknowledges the existence of these types of partnership interests and even gifted us 🎁 with standard profits interest safe harbor structuring to ensure we don't blow ourselves up 💥. The beauty of profits interest is that when done correctly, it's non-taxable at grant / vest - unlike your run of the mill equity interest. To keep it tax free at grant / vest - we look to Rev. Proc 93-27.

This IRS guidance can be summarized in this sample language I'd shared on Twitter / X some time back:

Effectively, the profits interest must have no inherent value at grant / vest. Meaning it must not immediately participate in profits - thus the reference to "hurdles." 🏃‍♂️

I see profits interest a lot - as it's akin to stock options for real estate bros 🕺 - but don't see this language in many Operating Agreements. It's one I usually propose when given the chance.

Elections

Operating Agreements prepared by attorneys who know a little about tax but have never prepared a tax return are the most dangerous. ⛔️

In preparing a return, there are several tax elections at your disposal ✅ - when and where to use those elections is a judgment call that should be left to the tax preparer and not mandated by the OA.

For example, many OAs will include a requirement for a §754 election. 🪜 But a wily tax preparer will know that not all eligible step-up (or step-down) transactions are worth going through this trouble for. But by having this language in the OA, the tax preparer is bound by it 😤 or has to get special approval from the GP and request an amendment to the OA.

Another example is accrual versus cash basis for tax filing purposes. This is also a judgment call that should be left to the tax preparer. Timing of income and expense is everything 🕰️, especially for small business. So tying the hands of the preparer by locking 🔒them into one type of income recognition basis isn't the best thing for the company.

Last example is timing of cost segregation studies. 🏢 I've seen examples of OAs including a timeframe for when the underlying asset would perform and implement a cost segregation study that accelerates depreciation deductions. While this is great for the offering memorandum in setting investor expectations - things change (like the tax code) 👨‍⚖️ and baking it into a document that binds the GP to that timeline isn't always the smartest route.

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Operating Agreements are like snowflakes ❄️ - each one unique and special in their own way. You should read yours, understand it, and customize it as you need so that it matches your business structure and expectations. The above were just a few examples of how you can approach that customization from the tax angle:

• Terminology
• Allocations
• Distributions
• Profits Interests
• Elections

Godspeed.

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