When drafting partnership and LLC operating agreements, addressing various tax considerations is crucial. This is equally important for multi-member LLCs treated as partnerships for tax purposes. To ensure your business complies with federal tax laws, here are several key tax issues that should be included in your operating agreement.
Identify and Outline Guaranteed Payments to Partners
Guaranteed payments in a partnership context are payments made by the partnership to a partner that meet these criteria:
- The partner is acting in their capacity as a partner,
- The payment is in exchange for services provided to the partnership or for the use of capital, and
- The payment is not contingent on the partnership’s income.
Special tax rules apply to guaranteed payments, so it’s essential that they’re clearly defined in the partnership agreement. Some important tax points include:
- The partnership generally deducts guaranteed payments according to its accounting method at the time they’re paid or accrued.
- For the individual partner, guaranteed payments are treated as ordinary income, subject to the maximum income tax rate, which is currently 37%. The partner must report the payment as income in the year that includes the end of the partnership’s tax year in which the partnership claimed the deduction, regardless of when the payment was actually received.
Address Tax Basis from Partnership Liabilities
Under partnership tax rules, a partner’s tax basis in the partnership interest increases based on the partner’s share of the entity’s liabilities. This creates a tax advantage because it allows the partner to deduct losses passed through from the partnership that exceed their actual investment, subject to various limitations like the passive loss rules.
Different rules apply to recourse and nonrecourse liabilities, impacting how a partner’s share of liabilities is calculated. The partnership agreement can influence how these liabilities are classified, so it’s important to account for this when drafting the agreement.
Clarify Payment Classifications for Retired Partners
Payments made to retired partners when liquidating their interest are subject to special tax treatment. This includes partners who have exited the partnership for any reason.
- Payments made in exchange for the retired partner’s share of partnership property are generally treated as ordinary partnership distributions. If these payments exceed the partner’s tax basis, the excess amount is taxable.
- Other payments made in the liquidation of a retired partner’s interest are either classified as guaranteed payments if they aren’t based on partnership income or as distributive shares of partnership income if they are. These payments are usually subject to self-employment tax.
To ensure the correct tax treatment, the partnership agreement should clearly define how payments to retired partners will be classified.
Consider Additional Partnership Agreement Provisions
With multiple partners, additional considerations often arise, even if you don’t anticipate them. A well-drafted partnership agreement can prevent disputes or complications down the road. You may want to include provisions for:
- A buy-sell agreement outlining what happens if a partner exits the partnership.
- A non-compete agreement to protect the partnership’s interests.
- A plan for handling a partner’s divorce, bankruptcy, or death. For example, will the partnership buy out an interest acquired by an ex-spouse or inherited by a beneficiary? If so, how will the buyout amount be calculated and when will payments be made?
Minimize Potential Liabilities
Properly addressing tax issues in your partnership or LLC operating agreement is critical to avoiding complications down the road. Contact us to ensure your agreement is drafted with these considerations in mind and to help minimize potential liabilities.
Q&As
What are guaranteed payments in a partnership, and how are they taxed?
Guaranteed payments are payments made by a partnership to a partner in exchange for services or capital use, not dependent on the partnership’s income. These payments are treated as ordinary income for the recipient partner, subject to a maximum income tax rate of 37%. The partner must recognize the payment as income in the tax year that includes the end of the partnership tax year in which the payment was deducted by the partnership.
How does a partner’s share of partnership liabilities affect their tax basis?
A partner’s tax basis in their partnership interest increases by their share of the partnership’s liabilities. This allows the partner to deduct passed-through losses that exceed their actual investment, subject to income tax limitations like passive loss rules. The classification of liabilities as recourse or nonrecourse can be affected by the provisions in the partnership agreement, making it crucial to account for these rules when drafting the agreement.
What are the tax implications of payments made to a retired partner?
Payments made to a retired partner in liquidation of their interest in the partnership are generally treated as ordinary distributions. If the payments exceed the partner’s tax basis in the partnership, the excess triggers taxable gain. Other payments are either classified as guaranteed payments (if they don’t depend on partnership income) or as ordinary distributive shares (if they do depend on partnership income). These payments are typically subject to self-employment tax.
What additional provisions should be considered in a partnership agreement?
A partnership agreement should address potential issues, even if they are not expected. Key provisions may include a buy-sell agreement for partner exits, noncompete agreements, and guidelines for handling events such as a partner’s divorce, bankruptcy, or death. For example, the agreement should outline whether the partnership will buy out an interest inherited after a partner’s death or acquired in a divorce and specify how buyout payments will be calculated and paid.
