Original article written by legacy firm, Harris Group Advisors (2024)
Partnerships are often utilized for business and investment activities, including multi-member LLCs that are treated as partnerships for tax purposes. These entities offer federal income tax advantages, the most important of which is pass-through taxation. They also must follow special and sometimes complicated federal income tax rules. Navigating these tax complexities can be difficult. We help our clients craft advantageous partnership and LLC operating agreements without confusion and hassle.
Governing Documents
A partnership is governed by agreements specifying the rights and obligations of the entity and its partners. Similarly, an LLC is governed by an operating agreement that specifies the rights and obligations of the entity and its members. These governing documents should address specific tax-related issues. Here are some key points when creating a partnership and LLC governing documents.
Partnership Tax Basics
The tax numbers of a partnership are allocated to the partners. The entity issues an annual Schedule K-1 to each partner to report his or her share of the partnership’s tax numbers for the year. The partnership itself doesn’t pay federal income tax. This arrangement is called pass-through taxation. The tax numbers from the partnership’s operations pass through to the partners, who then take them into account on their tax returns. This is Form 1040 for individual partners.
Partners can deduct partnership losses passed through to them, subject to various federal income tax limitations such as the passive loss rules.
Issues When Switching Methods
Special Tax Allocations
Partnerships are allowed to make special tax allocations. This allocation of partnership loss, deduction, income, or gain among the partners is disproportionate to the partners’ overall ownership interests. The best measure of a partner’s overall ownership interest is the partner’s stated interest in the entity’s distributions and capital, as specified in the partnership agreement. An example of a special tax allocation is when a 50% high-tax-bracket partner is allocated 80% of the partnership’s depreciation deductions. At the same time, the 50% low-tax-bracket partner is allocated only 20% of the depreciation deductions.
Any special tax allocations should be outlined in the partnership agreement. However, to make valid special tax allocations, you must comply with complicated rules in IRS regulations.
Distributions to Pay Partnership-Related Tax Bills
Partners must recognize taxable income for their partnership income and gains allocations, whether those income and gains are distributed as cash to the partners or not. Therefore, a common provision in partnership agreements calls for the partnership to make cash distributions to help partners cover their partnership-related tax liabilities. Of course, those liabilities will vary depending on the partners’ specific tax circumstances. The partnership agreement should specify the protocols to be used for calculating distributions intended to help cover partnership-related tax bills.
For instance, the protocol for long-term capital gains may require distributions equal to 15% or 20% of each partner’s allocation of the gains.
Such distributions may be paid out in early April of each year. This helps cover partners’ tax liabilities from their allocations of income and gains from the previous year.
Contact Us for Assistance
When forming a partnership or LLC, tax issues should be addressed in the agreements. Contact us to be involved in the process.
Original article written by legacy firm, Harris Group Advisors (2024)
