Tax Considerations for Operating Agreements

While tax strategies may not come to mind when drafting an operating agreement for your LLC business, they can have a direct impact on your finances. These are the common tax issues to note on different types of operating agreements.

While tax strategies may not come to mind when drafting an operating agreement for your Limited Liability Company (LLC) business, they can have a direct impact on your finances. These are the common tax issues to consider, depending on the type of operating agreement. When forming a partnership, tax considerations for an LLC are significant and should be in your operating agreement describing percentages of ownership and liabilities. If you do not have a written and signed contract between partners or have an existing operating agreement, tax and accounting advice may be helpful as accounting and allocating partner ownership for tax purposes can be very complicated. An experienced CPA with taxation expertise is beneficial to ensuring and verifying operating agreements for partnerships comply with Internal Revenue Code.

What is an Operating Agreement?

According to the Small Business Administration (SBA), operating agreements are fundamental documents outlining the provisions, rules, and regulations of a partnership. For a business operating agreement to be legally binding, all parties must sign the contracts agreeing to the terms, including tax liabilities and profit & loss distributions. Keep all binding contracts or operating agreements for corporations confidential as you do other private documents of the organization. Our CPAs know the complexity of tax considerations for business partners and are skillful in analyzing and modifying operating agreements.

Differences Between Operating Agreements for Corporations and LLCs

While an LLC must have an operating agreement in some states, registered corporations, such as S corporations or C corporations, have bylaws explaining the regulations and rules. A corporation’s bylaws generally comprise an organizational structure, responsibilities of its members, board of directors, and meetings between directors and shareholders. The Secretary of State in most states does not require LLCs or corporations to file operating agreements or bylaws. Users of the confidential documents include banks, attorneys, CPAs, investors, and lenders.

Five Common Issues Involving Tax Considerations for Operating Agreements

1. Taxation of LLCs

All partners of an LLC must file a federal income tax return with the Internal Revenue Service and report their share of profits and expenses in the partnership. Section 1.704-1 (b)(2)(ii)(h) reads that the articles of an LLC and the operating agreement should receive an examination to determine the economic arrangement of members and its effect. If you and your partners made verbal agreements or modifications for legal and tax purposes, it is time to consult with a CPA firm. All operating agreements should be in writing and signed by the partners stipulating the agreed and modified sections of the LLC operating agreement. Tax Considerations for Operating Agreements are different from the prior agreements before 2015, which is why corporations and limited liability companies should seek professional tax advice.

2. Outdated Operating Agreements

Updating your existing business operating agreement must include a partners’ representative, a part of the 2015 Bipartisan Budget Act. The new rule permits the Internal Revenue Service to access tax liabilities of partners reported in prior years and in audits. Being knowledgeable of this information can be helpful for you to avoid tax penalties and fines for violations of the Internal Revenue Code.

3. Distribution and Allocation of Net Profits and Losses

Distributing available cash among your shareholders or partners is a section of operating agreements for corporations or LLCs that can be extremely complex, along with allocating net profits, losses, and gains. Issues can also arise when the distribution of cash proceeds from operations differ from the partners’ capital transactions.

4. Allocating Tax Obligations of Non-Controlling Partners

A common issue is determining if non-qualifying partners need to receive a Form K-1 or be subject to different tax consequences. Under Section 704 (c)(1)(A) of the Internal Revenue Code, partners must share income, gains, losses, and deductions of the partnership.

5. Distribution of Tax Liabilities

Distributing tax liabilities can be complicated to calculate for each partner. CPAs can help by using a formula to determine the maximum possible tax liability of the partners and tax distributions. An operating agreement should include a section for tax withholding with each partner agreeing to comply with the withholdings from distributions. For C corporations, knowing how to treat distributed amounts can also be difficult, whether as a loan or an advance against distributions in the future. Fusion CPA can help walk through operating agreement tax considerations for your LLC, partnership, or corporation. Having a Certified Public Accountant prepare your tax return ensures that profit and loss tax allocations, along with cash distributions from operations, are accurate when accounted for in financial reports and federal income tax returns. If a problem is discovered such as an invalid tax allocation, we will immediately inform you of the situation and recommend the necessary corrections to be made.

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This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. Articles are based on current or proposed tax rules at the time they are written, and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.