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Understanding Tax Provisions in An LLC Operating Agreement - Formation Concepts Part 1: Capital Accounts Compared to Stock



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Understanding Tax Provisions in An LLC Operating Agreement - Part One of Three

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This is a three-part series that discusses the formation tax provisions included in most tax partnerships and operating agreements. An attorney/CPA and director of a major Graduate Tax Program frequently stated that 90% of the attorneys that drafted partnership and operating agreements could not explain and did not understand what most of the tax provisions meant. Unfortunately, the percentage may be slightly higher, and therefore this is the purpose of this three-part webinar series on formation issues.

C corporation tax attorneys, flow through (partnership and S Corporations) tax attorneys; and estate planning attorneys usually come from very different backgrounds. Even if an estate planning attorney has an LLM in taxation, most likely they only received one partnership taxation course, and this one graduate tax partnership course generally did more to confuse than to explain it! Unfortunately, many of us were never exposed to this area, but it's critical to understand these concepts because most estate planning deals with family-owned businesses. 

The purpose of this three part series is so that estate planners understand some of the key tax provisions in a partnership or operating agreement as well as can avoid some of the more common pitfalls in the formation area. 

Part 1 covers the distinctions between capital accounts and stock, and Mark will cover these important planning issues:

  • Most business owners as well as attorneys mistakenly believe that capital accounts work like stock ownership
  • Further, some drafting attorneys even try to manipulate the operating agreement to accomplish this, not knowing all of the provisions that need to be changed
  • For example, what are the 3 main differences between book and tax capital accounts?
  • Better yet, what is book capital account in the first place, and why does the operating agreement state that liquidating distributions are made based on “positive capital accounts”?
  • Unfortunately, most drafters mistakenly assumed that liquidating distributions were based on the profit and loss ratio – like ownership of stock in a corporation

Part 2 covers the the issues surrounding the potential triggering of gain when contributing property to a partnership, and Mark will review the critical planning issues that are raised in this all-too-common fact pattern:

  • Estate planners form entities (generally LLCs and FLPs) and then have the client contribute property to these entities.
  • Then the estate planner may begin gifting such entities to trusts or directly to other family members.
  • However, few estate planners understand that gain may be triggered on contribution if the property is subject to a debt or if the contribution is to a foreign partnership.
  • Further, few estate planners understand how these rules are different for a corporation (C or S corporation) when compared to partnership taxation.

Part 3 covers deducting losses and four critical tax hurdles:

  • Are you frustrated when hearing terms such as “basis,” “at risk,” “passive loss”, and IRC § 461(l)?
  • Why are most planners familiar with the concept of recourse and nonrecourse debt, but very few can explain it when an entity is involved?
  • Why is the most common mistake with an S corporation thinking that the partnership basis rules apply?
  • Proper planning in this area frequently results in shareholders of S corporations from being able to deduct losses currently.


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