When you’re setting up partnership and LLC operating agreements–including for multi-member LLCs, which are treated as partnerships for tax purposes, there are a few key issues to include in your agreement to keep your business in line with federal tax law.
Spell out guaranteed payments to partners
A guaranteed payment is one made by a partnership that’s:
- to the partner acting in the capacity of a partner
- in exchange for services performed for the partnership or for the use of capital by the partnership, and
- not dependent on partnership income.
Since guaranteed payments are subject to specific tax rules, they should be identified and outlined in the partnership agreement. For example:
- The partnership typically deducts guaranteed payments based on its accounting method when they’re paid or accrued.
- When a partner receives a guaranteed payment, it’s considered ordinary income, currently taxed at the top rate of 37%. The partner must recognize this payment as income in the tax year that includes the end of the partnership’s tax year when the payment was deducted–even if the partner doesn’t receive the payment until the following year.
Leverage tax basis from partnership liabilities
Partners get additional tax basis from their share of the partnership’s liabilities interest, allowing them to deduct more passed-through losses (within IRS limits).
Since different rules apply to recourse and nonrecourse liabilities when determining a partner’s share of liabilities, be sure to include these provisions when creating your partnership agreement.
Define payments to retired partners
Special tax rules also apply to payments made when a partner leaves and their interest in the partnership is liquidated. This applies to any partner who exits for any reason.
Typically, payments for a retired partner’s share of partnership property are treated as ordinary partnership distributions. If these payments exceed the partner’s tax basis in the partnership interest, the extra amount triggers taxable gain for the partner receiving it.
Other payments in a partner liquidation are either 1) guaranteed payments if amounts don’t rely on partnership income, or 2) distributive shares of partnership income if they do. These payments are generally subject to self-employment tax.
Your partnership agreement should specify how payments to retired partners are classified to ensure the correct tax rules apply.
Build in provisions for long-term stability
With multiple partners, unexpected circumstances can arise, but a well-crafted partnership agreement outlines a straightforward course of action for such situations. Consider including provisions like:
- A buy-sell agreement for partner exits
- A noncompete clause
- Guidelines for handling divorce, bankruptcy, or death of a partner. Will the partnership buy out an interest acquired by a partner’s ex-spouse or inherited after a partner’s death? If so, what will the payment arrangements look like, and when will they be finalized?
Control your liability risk
When you put together a partnership deal, you should take a proactive approach to compliance. Contact your Smolin advisor to make sure your agreements cover all the essentials and are built to last.