When drafting partnership and LLC operating agreements, especially for multi-member LLCs treated as partnerships for tax purposes, it’s crucial to address various tax issues to ensure compliance with federal tax law. Below are essential tax topics to cover in your agreement.
Guaranteed Payments to Partners
Guaranteed payments are defined for tax purposes as payments made to a partner who is acting in their capacity as a partner, either for services performed or for the use of capital contributed to the partnership, and that are not contingent on partnership income.
Special tax rules apply to guaranteed payments, so it’s important to outline these in your partnership agreement:
The partnership typically deducts guaranteed payments when they are paid or accrued, in line with its accounting method.
For individual partners, guaranteed payments are treated as ordinary income and are currently subject to a maximum tax rate of 37%. The partner must report the guaranteed payment as income in the tax year that includes the end of the partnership’s tax year in which the payment was deducted, even if the partner receives the payment in a later tax year.
Tax Basis from Partnership Liabilities
Under partnership tax rules, partners gain additional tax basis in their partnership interest based on their share of the entity’s liabilities. This basis increase can allow a partner to deduct passed-through losses that exceed their actual investment in the partnership, though various income tax limitations (such as passive loss rules) may apply.
The partnership agreement should address how to classify partnership liabilities as recourse or nonrecourse, as different tax rules apply to each. Provisions in the agreement can affect this classification, which has implications for the partners' tax basis and potential deductions.
Classification of Payments to Retired Partners
Payments made to retired partners, including those who leave the partnership for any reason, are also subject to specific tax treatment:
Payments made in exchange for the retired partner’s share of partnership property are generally treated as standard partnership distributions. If these payments exceed the retired partner’s tax basis in their partnership interest, the excess is taxable gain.
Other payments in liquidation of a retired partner’s interest may be classified as either guaranteed payments if not dependent on partnership income or as distributive shares of partnership income if income dependent. These payments are generally subject to self-employment tax.
The agreement should clarify the classification of payments to retired partners to ensure the correct tax rules are applied.
Additional Provisions to Consider
If your partnership involves multiple partners, it’s wise to anticipate and address other potential issues in the partnership agreement, even if they don’t seem immediately relevant. For example:
A buy-sell agreement for handling partner exits.
A noncompete clause.
Provisions on how to manage the divorce, bankruptcy, or death of a partner. For instance, will the partnership buy out an interest that is transferred due to a divorce or inherited upon a partner’s death? If so, how will the buyout be valued and paid?
Protect Your Partnership from Tax Liabilities
Tax considerations are an integral part of any partnership agreement. Contact us for guidance to help you address these issues and ensure that your agreement is thorough and compliant.