Whether you're structuring a new partnership or updating an existing LLC operating agreement, understanding the tax implications of your decisions is critical. Partnerships and multi-member LLCs are subject to specific tax rules that must be addressed in their operating agreements to avoid future tax liabilities.Guaranteed Payments
One important tax issue that needs to be addressed in the operating agreement is guaranteed payments. These are payments made to partners regardless of the partnership's income, typically for services rendered or the use of capital. Guaranteed payments are taxed as ordinary income to the partner and are deductible by the partnership.

For example, if a partner is guaranteed a $50,000 payment each year for managing the business, this amount is included in the partner's taxable income, even if the partnership incurs a loss. The partnership can deduct the payment, reducing its taxable income. However, the timing of these payments and the partner's tax liability must be considered carefully to avoid cash flow issues.

Tax Basis and Partnership Liabilities
Another key consideration is how the partnership's liabilities affect each partner's tax basis. Under the partnership taxation rules, a partner's tax basis is increased by their share of the partnership's liabilities. This increase in basis can allow the partner to deduct more losses, providing a significant tax advantage.

However, not all liabilities are treated the same. The distinction between recourse and nonrecourse liabilities is important for determining how much basis a partner receives. Recourse liabilities are those for which the partner is personally liable, while nonrecourse liabilities are secured by the partnership's assets. The partnership agreement should clarify how liabilities will be allocated to ensure compliance with tax law.

Payments to Retired Partners
Special rules also apply to payments made in liquidation of a retired partner's interest. These payments are typically classified as either guaranteed payments or distributions. Guaranteed payments are subject to self-employment tax, while distributions may be taxed as capital gains, depending on the partner's basis in the partnership.

Carefully defining how these payments will be classified in the operating agreement can help prevent unexpected tax consequences for both the retired partner and the remaining partners.

Additional Provisions to Consider
While tax issues are critical, there are several other provisions that partnerships and LLCs should consider including in their agreements. These include:

• Buy-sell agreements to govern what happens if a partner wants to exit the business.
• Noncompete agreements to prevent partners from starting a competing business.
• Provisions for dealing with the death, divorce, or bankruptcy of a partner to ensure continuity of the business.

We Can Help
Navigating the tax rules for partnerships and LLCs can be complex, but we're here to help. Contact us to ensure your partnership or LLC operating agreement complies with federal tax law and protects your interests.