A partnership agreement (or operating agreement, in the case of a limited liability company) may be the single most important agreement a partnership will enter into. Considered the foundation of any business deal, partnership agreements define the shared understanding regarding the economic rights and obligations of an entity’s partners and the governance of the entity. Aside from the numerous legal binding aspects, it is important for businesses to fully understand what the agreements entail from an income tax perspective.
Allocation of income and loss
Partnerships are not taxable entities for federal income tax purposes. Instead, they pass the results of the operations to the partners who will ultimately bear the tax consequences of the partnership’s activities. Moreover, partnerships can accommodate a wide array of economic arrangements and the regulations authorize the partners to share the income and loss items regardless of capital commitments, and to establish different ratios for sharing various items.
For example, partners may allocate losses in a different manner than income. Accordingly, it is critical to document in detail how the partners will share the economic benefits and burdens of the deal.
As a result, one of the most important provisions in a partnership agreement is the allocation of income and loss. These provisions can become complex to accommodate for the flexibility afforded to partners and, in many cases, will cross-reference other provisions (such as distributions) and will use special terms to describe preferential allocations. Therefore, it is imperative to evaluate various “what-if” earnings scenarios with a tax professional, including both profit and loss situations before the partnership agreement is finalized to visualize the outcomes of such allocations from a tax standpoint.
Additionally, for the allocations to be respected for federal income tax purposes, they must have “substantial economic effect” ensuring that each partner receives their appropriate share of the business’s taxable income or loss, based on how the partners share the economic benefits and burdens of the partnership’s operations.
Discussing all scenarios provides an understanding of whether the partnership agreement reflects the partners’ intended purpose. If the partnership agreement is already finalized, exploring these hypothetical situations might result in potential amendments to make sure it is what the partners agreed upon.
For the reasons mentioned above, drafting the appropriate provisions is not an easy task and the consequences of misinterpretation could result in incorrect tax filings, which in turn will require filing amended returns or administrative adjustment requests, as well as incurring penalties and interest.
Partnership audit rules
Partnerships are subject to the centralized partnership audit regime unless an election out is made, which is only available to partnerships with specific ownership structures. Under this regime, the partnership, rather than its partners, will be liable for any tax underpayments, along with penalties and interest, unless a push-out election is made where the partners become liable for the tax. Whether this election should be made by the partnership representative should be addressed in the partnership agreement. Issues arise when these adjustments pertain to tax years whose partners are no longer in the partnership. The agreement should address the prior partners’ obligations in order to not expose current partners to tax liabilities related to years before they were partners.
Partnerships should also address the following issues in the agreement to help avoid problems under the centralized partnership audit regime:
- Designating a partnership representative (PR) who will receive all audit-related correspondence from the IRS and have broad authority to bind the partners for purposes related to the partnership audit rules.
- Determining whether an election out of the centralized partnership audit regime will be mandatory for eligible partnerships.
- Establishing if the partnership is required to make a push-out election or the circumstances when a push-out election will be made.
- Specifying whether the consent of a majority of the members is needed to make the elections.
- Detailing if current partners are required to make capital contributions to cover for any assessed taxes and penalties.
An attorney should be consulted to advise on all aspects of a partnership agreement and to draft the document, which may include sections covering:
- General provisions.
- Capital contributions and distributions, partners’ loans, maintenance of capital accounts and partners ownership percentages.
- Management, liability and compensation provisions.
- Transfers, withdrawals, and partnership interest buyouts.
- Dissolution, termination and indemnification.
- Terms and definitions.
It is also useful for a partner to engage their own attorney to review the agreement once it has been drafted.
There are numerous complexities to consider when evaluating the income tax provisions in partnership agreements. Citrin Cooperman’s tax professionals are equipped to help you make informed choices that will best support the growth and goals of your strategic vision. For more information, please contact Ibrahim Kousan at firstname.lastname@example.org or email@example.com.
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