Preface: Tax codes and their implications to partnership or operating agreements may be like deciphering hieroglyphics to some entrepreneurs yet the implications of a well-written tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement by working with your attorney to keep you in compliance with tax laws. Here are examples of how they can add value.
A CPA Can Provide Valuable Opinions on Partnership or LLC Agreements
Credit: Donald J. Sauder, CPA
Business’s taxed as a partnership filing a Federal Form 1065 for tax purposes always involve more than one individual or entity in ownership. The “agreement,” whether a partnership agreement for a general partnership (GP) or limited partnership (LP) or an operating agreement say or an LLC, outlines the business rules and legally describes the business relationship with rights and responsibilities among ownership.
Often an attorney tailors these agreements as “boiler plate” papers that may omit certain key characteristics or be ambiguous on certain details of the business relationship, e.g. distributions of cash, buy/sell terms, earnings or loss allocations or management oversight. While a CPA cannot write a partnership agreement or operating agreement, (it would be prohibited as unauthorized practice of law or UPL); they can provide valuable insights into aspects of the business agreement document.
There is a story where Noble Prize winner Richard Feynman was visiting a Tennessee plant where the atomic bomb was to constructed. Feynman was confused about a unique symbol on the blue prints, and not being an expert on reading design prints, he needed to know what he did not understand. As an expert authority on the project he took a risk and ask “what happens if that value gets stuck”. He feared the answer might be a response that would make him appear ignorant to the group. The engineer assigned to answered needed to trace the blue print to answer his question, discovering a serious design flaw that could have destroyed the Facility. When Feynman was asked later how he identified the problem, Feynman’s answer was “sometimes you just need to ask if it’s a value;” when in actuality he simply ask a direct question. Why hadn’t anyone else in the entire group asked? Moral: group collaboration has benefits. Feynman humble approach to understanding what he did and did not know was very helpful to the other experts.
One reason a CPA can provide value to business agreements is that they understand the tax aspects of the agreement. Some attorneys have tax expertise; but wordsmithing and tax are two different areas. In corporate agreements or LLC’s taxed as S-Corporations, the distributions provisions per ownership in S-Corporations can be an important detail to tax compliance. For instance, what if a shareholder draws a disproportionate share of capital during the year? Does the agreement resolve the tax risk? Secondly the economic arrangement of distributions whether liquidating distributions or special allocations including preferred returns or guaranteed payments and tax distributions are best described and agreed upon at the signing of the partnership agreement. Thirdly, many agreements boiler plate 704(b) book capital with three safe harbors.
Typically well versed agreements hold the most value in challenging business ownership situations and therefore an improperly drafted agreements that doesn’t prioritize distributions of capital can lead to substantial risks for agreements in a liquidation, or restructuring, e.g. say an agreement provision requiring capital accounts to at all times be in accordance with Code Section 704(b) regulations and qualified income offset provisions provide clear details on what happens if a capital goes negative.
Guaranteed payments on capital or for services should be specifically outlined in numeric terms with schedules with addendum updates following to that the business relationship on capital is well documented, e.g. A CPA can help assess if rates on capital are necessary.
In addition, allocations of profit and loss and an agreement on economically accrued earnings and distributions of built in gains or basis step-up on ownership changes are all relevant to a well-crafted agreement.
Another item is Code Section 469 Regulations on economic groupings or activities, a business agreement should outline who has authority to make grouping elections for the business or decision making authority with regards to an appropriate economic unit. An agreement can even state that a tax filing must be made available before a certain day, requiring adherence to tax filing deadlines among management. A CPA can also help edit boiler plate documents to not require a partnership be bound by Code Section 754 elections for basis adjustment.
While some of the Code Sections and tax implications of partnership or operating agreements described above may be like deciphering hieroglyphics to some entrepreneurs, the implications of a well-written, tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement, by working with your attorney to keep you in compliance with tax laws.
While paper sits quietly for anything, a well-documented business agreement is well-advised for your business.