Tax Considerations for LLC Operating Agreements

July 30, 2020

The operating agreement is the governing document with respect to the management and conduct of a limited liability company (an “LLC”). It outlines the financial and functional decisions of the business and, once signed, binds members to its terms. When negotiating an operating agreement, it can be tempting to conclude that simple operating agreements do not need tax review, especially when clients are clamoring for quicker turnaround times and lower bills. But there are some common tax issues that are worth noting.

1.    Partners.[1] While not an actual provision, sometimes the first step in the tax review will be confirming that all of the partners (or members) for legal purposes are in fact also partners for U.S. federal income tax purposes. Tax partners should share in the profits, as well as the expenses, of the venture, so a partner that is entitled only to a share of the entity’s gross revenue should be examined closely. Partners that do not qualify as tax partners may be surprised to learn that they will not receive a Schedule K-1 and that they will have different tax consequences than tax partners.

2.    Tax Decisions. It’s important to consider what role non-controlling partners will play in important tax decisions. One of the advantages of partnerships (and LLCs that are treated as partnerships) is that they generally afford the opportunity for a single level of taxation solely at the partner level. Partners that want to ensure that the entity continues to be treated as a flow-through for U.S. federal income tax purposes should prohibit the partnership from electing corporate status without the consent of each partner. In addition, the allocation methodology selected under Section 704(c) of the Internal Revenue Code can be an important, and potentially contentious, decision where a partner contributes appreciated property, instead of cash, to the partnership. Partners should consider who has the right to choose the 704(c) method or select a particular method to be specified in the agreement.

3.    Partnership Representative. A clear indication that you have an outdated operating agreement is the absence of the term “partnership representative.” In the past, most agreements provided for a “tax matters partner,” a role that has now essentially been replaced by the “partnership representative” as part of the Bipartisan Budget Act of 2015 (the “BBA”). The BBA created a new centralized partnership audit regime, generally effective for tax years beginning after December 31, 2017. The new rules, most notably, allow the IRS on audit to assess tax liability for prior years at the partnership level in the year of the IRS’s determination. So, unless certain elections are made, a current partner that was not a partner in the year under audit could be hit with unexpected tax liability. Partners should, therefore, consider the applicability of the various elections, including the election to opt out of the new audit rules entirely, and provide for their preferences in the agreement. In addition, the partnership representative should be chosen carefully because, from the IRS’s perspective, such person will have the exclusive authority to represent the partnership in IRS proceedings and agree to settlements. The other partners should nonetheless negotiate notification and oversight rights in the agreement, but it’s important to bear in mind that those contractual provisions are not binding on the IRS.

4.    Distributions and Allocations. While distributions govern the division of available cash among the partners, allocations divide net profits and losses (and individual items of income, gain, loss, deduction and credits) among the partners. Allocations are reflected in the capital account that is maintained for each partner. It is recommended that allocations generally correspond to the economics of the partnership in order to avoid a challenge by the IRS in the event of an audit. For example, where distributions are made in accordance with percentage ownership interests (or a similar metric), it will be easy to provide that allocations are also made in accordance with that metric, and then liquidating distributions can be made in accordance with positive capital account balances. Allocation provisions will be more complicated where there is a preferred return or a “promote” structure, or where cash proceeds from operations are distributed differently from cash proceeds from capital transactions. Another method some partnerships employ is “targeted allocations” (also known as “forced allocations”), which allocate partnership items for the year so that the partners’ capital account balances equal the amounts the partners would receive under the distribution provisions in a hypothetical liquidation of the partnership, essentially forcing the allocations to match the distributions. To avoid a circular result, an agreement that uses “targeted allocations” should not provide for liquidating in accordance with capital account balances.

5.    Tax Distributions. Because partners are subject to tax as income is earned by the partnership even in the absence of any distributions (a problem that is generally referred to as “phantom income”), partners will generally want tax distributions to be made on a regular basis to ensure that they have sufficient cash to cover their tax liabilities in respect of the partnership. The operating agreement will generally include a formula for determining the maximum possible tax liability of the partners, and any tax distributions made to a partner are typically treated as an advance against the partner’s regular distributions. Among other points, partners should also consider who determines whether cash is “available” for distributions to pay tax liabilities and whether tax distributions will be required quarterly or only annually.

6.    Withholding. Many operating agreements explicitly provide that the partnership will comply with its tax withholding obligations. The agreement should also provide that amounts withheld from a distribution to a partner are treated as distributed to such partner for all purposes of the agreement. Partners should also decide how to treat taxes that are measured by a partner’s distributive share of partnership net income or gain but that do not correspond to amounts being distributed (as these taxes can’t be simply withheld from a current distribution). Typically, those amounts would be treated as a loan to the partnership from the applicable partner and/or as an advance against the partner’s future distributions.

7.    Transfers. Older agreements may disallow transfers that trigger a Section 708(b)(1)(B) termination as a result of a sale or exchange of 50% or more of the total interests in partnership capital and profits within a 12-month period. This one is a harmless error, but it’s worth striking – that section was removed from the Internal Revenue Code as part of the Tax Cuts and Jobs Act for partnership tax years beginning on or after January 1, 2018.

8.    Tax Returns. The operating agreement should also provide for the timely filing of all required tax returns and the delivery of Schedules K-1 to all partners. A non-controlling partner will likely want to add the right to receive sufficient information to enable it to make quarterly estimated tax payments.

This article is meant to highlight just some of the tax issues that you may encounter in connection with your operating agreement and should not be treated as a substitute for individualized tax advice. If you have any questions about tax issues in operating agreements, you should call your tax advisor, or please do not hesitate to contact me.

[1] This article uses the terms partnerships and partners to match the tax terminology, but the discussion here applies equally to LLCs that are treated as partnerships for U.S. federal income tax purposes and members of those LLCs. This discussion will not be relevant to LLCs that are treated as corporations for U.S. federal income tax purposes.

  • Related Practice Areas: Corporate, Tax