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!
Your Operating Agreement has a Memory Problem 🤕
|
It's that time of the quarter: the check-in on whether your operating agreement will survive tax scrutiny. Today I want to show you the section I check first on every agreement. 👉 Liquidating Distributions 👈 What this section doesWhen the partnership sells and winds down, this section decides who gets the money. Most read the same way: creditors first, then partner loans, then the partners. The middle can get nuanced. The ending can't. The final split has to match the real economics of the deal. The partners who were allocated the income get the cash 🏦, and the partners who were allocated the losses don't. That's the theory. Here's where it breaks. The red flagWatch for language like this:
"Liquidating distributions will be made in accordance with the partners' sharing ratios." 🚩🚩🚩
Six words, "in accordance with sharing ratios," and I already know this agreement has a problem. ✍️ Here's why. Sharing ratios have no memory. They don't care that Partner A absorbed three years of losses while Partner B took the income. Come sale day, this language splits the cash like none of that ever happened. That's not good - we need to remember. Follow it literally and you get the doomsday scenario: final K-1s with capital account balances still sitting in them. Or worse... final K1 negative balances. That's the paper trail saying income and losses went to the wrong partners for years, and now the deal is over and there's no cash left to fix it. 💣 Your accountant is stuck choosing between the agreement and the tax law. And whichever way they go, the LP questions never end. What the tax code requiresQuick refresher: a capital account is each partner's running scorecard. Contributions and income push it up. Losses and distributions pull it down. The safe harbor allocation rules have three requirements, and this is one of them: Liquidating distributions must be made in accordance with positive capital account balances. Not sharing ratios. Capital accounts. Say one partner has a $0 capital account at liquidation and the other has $100,000. Under the safe harbor, sharing ratios and promotes are disregarded. The partner with the positive capital account gets the cash. The scorecard decides. 👨⚖️ That's the whole point. It stops partners from taking losses all along and grabbing the cash at the end. One acceptable alternative: the liquidating distributions section can point to the waterfall instead - if the allocations section uses "target capital" language. Different route, same destination. Economic effect is still satisfied. The TakeawayPull up your agreements and read the liquidating distributions section. 🔍 If it's a cold, hard reference to sharing ratios, you may have some amending and restating to do. Fix it now, on paper, while it's cheap. The alternative is asking your accountant to untangle years of allocations in the final year of the deal.. under an agreement that may not even allow it. If you sign operating agreements as an LP or GP, or you draft them as an attorney, the link below covers how I help every side of the deal get the tax language right. Or just reply to this email. 🫡 Group Chat Worthy Posts 🔥📲
Want to read previous issues? Click here. |
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 👇 Also on YouTube at PlugAccountingandTax!
Calls with prospective clients often turn into "show me what you got" contests. But tax strategy doesn't work like that... It's a multi-phase process of decision making. Before we name a single strategy, we have to answer three questions about you. The answers decide which moves are on the table and which are noise. And this process compounds with time - as we learn your tendencies, goals, and risk appetite. And with our selling season picking up steam, I wanted to share how we think about...
I met with a young business owner this week - one of his questions is the most common ones I get asked all the time. "I took out $150,000 from my business, so I'm going to have to pay tax on that right?" The answer in his case was, "you already have." He stared blankly back at me and we ran through this concept 👇 When a Distribution is Taxable If you own a "pass-through" business (you get a K1, or are a sole proprietor) then you get taxed income of the business whether you take out a...
The best attorneys are specialists - ideally at keeping you out of trouble. This specialization mostly comes in the form of transaction structuring, risk identification, or legal procedures. A few of them have taken a wrong turn and wound up as tax attorneys. But of those few, even fewer have ever filed a tax return or allocated income and loss on K1s. Which is a shame because that's an experience that is sorely needed when drawing up operating agreements. I've been reviewing operating...