Understanding the Tax Sections of Operating Agreements

February 15, 2022  | By Erik Lincoln

Many consider an operating agreement [1] (“OA”) to be a complex maze of odd tax terms.  And, with defined terms like, Minimum Gain, Nonrecourse Deductions, and Qualified Income Offset, they may be right.  In this two-part article, we provide a basic understanding of the following: (1) the definition of twelve of the most common tax related terms found in OAs, and (2) why these terms are there.

The twelve tax related terms we discuss include:

  1. Capital Account,
  2. Profits and Losses,
  3. Gross Asset Value,
  4. Depreciation,
  5. Nonrecourse Debt,
  6. Nonrecourse Deductions,
  7. Minimum Gain,
  8. Minimum Gain Chargeback,
  9. Loss Limitation,
  10. Gross Income Allocation,
  11. Qualified Income Offset, and
  12. Curative Allocation.

(Referred to herein as the “Tax Related Terms”)

Why are the Tax Related Terms Included in OAs

To understand why the above Tax Related Terms are included in OAs, it is helpful to understand certain income and loss allocation rules found in the Internal Revenue Code (“Code”).  The Code contains rules considered to be a safe harbor for allocating income and loss such that if a taxpayer complies with the safe harbor rules, their allocations will not be subject to IRS scrutiny.  These safe harbor rules are found in §704(b) of the Code and Treasury Regulations (the “Safe Harbor Rules”) and the Tax Related Terms come from these Safe Harbor Rules.

The primary purpose of the Safe Harbor Rules is to ensure certain tax policies are not subverted.  One such tax policy is that if an individual is allocated a certain amount of income (for which they pay tax on), they (and not someone else) should receive the economic benefit related to their income allocation.  In other words, if a member is allocated $100 of income, they should receive $100 of distributions over the life of the LLC.

In some situations, though, parties choose not to comply in all respects with the Safe Harbor Rules.  This is commonly done with private equity partnerships where it is more important to provide easier to understand allocation terms that are less likely to alter the expected economic deal (i.e., distribution waterfall).[2]  But, even in situations where the Safe Harbor Rules are not technically followed in an OA, the Tax Related Terms are included so the LLC/partnership complies as closely as possible with the Safe Harbor Rules.

Because the Tax Related Terms stem from the Safe Harbor Rules, we provide an overview of the Safe Harbor Rules in the next section of this article.

Safe Harbor Rules

The Safe Harbor Rules state that if “an allocation does not have substantial economic effect, then the member’s/partner’s distributive share of such income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with such member’s/partner’s interest in the partnership.”

Based on the above, if an allocation does not have, what is referred to as “substantial economic effect”, the IRS can reallocate income, gain, loss, deduction, or credit….to be in accordance with the partner’s interest in the partnership.  Most people prefer to avoid the possibility of the IRS reallocating partnership income or loss.  This is done by drafting the OA to comply with the Safe Harbor Rules.

Whether an allocation has substantial economic effect is a two-part test – the allocation must be “substantial” and it must also have “economic effect”.  We do not cover the meaning of substantial here because that concept has little to do with the meaning of any of the Tax Related Terms.  Instead, we focus on what is meant by economic effect.

In order for an allocation to have economic effect, the allocation must meet one of three tests: The Primary Test, The Alternate Test, or The Economic Equivalency Test. The Primary Test and The Economic Equivalency Test are not frequently relied on, so we do not cover those here and instead focus on The Alternate Test.  The Alternate Test has three requirements, which include:

  • – The Capital Account Maintenance Requirement,
  • – The Liquidation Requirement, and
  • – The Qualified Income Offset Requirement.

Each of The Alternate Test requirements is discussed below.

The Capital Account Maintenance Requirement

The Capital Account Maintenance Requirement requires that an LLC / partnership maintain a capital account for each member.  The purpose of this requirement is to track each member’s economic investment in their LLC / partnership.

A member’s economic investment consists initially of capital contributions (cash + fair market value (“FMV”) of property, net of liabilities associated with the property) made in connection with the formation of the LLC / partnership.  After that, capital accounts are adjusted as follows to track the economics of a member’s investment:

Capital accounts are increased for the following:

  • – The amount of book profits allocated to the member.
  • – The amount of any LLC / partnership liabilities assumed by a member, or which are secured by any LLC /partnership property distributed to such member.
  • – The FMV of additional contributions.

Capital accounts are decreased for the following:

  • – The amount of book losses allocated to the member.
  • – The amount of cash and FMV of property distributed to the member.
  • – The amount of any liabilities of the member assumed by the LLC / partnership or which are secured by any property contributed by such member to the LLC / partnership.

Capital accounts are intended to represent each member’s share of the LLC’s / partnership’s assets.  One simplistic way to view capital accounts is to think of them like savings accounts for the members.  When contributions or income allocations occur, the savings account / capital account goes up and when distributions are made or losses are allocated, the savings account / capital account goes down.  And, when the partnership liquidates, each member should receive what remains in their savings account / capital account.

Capital accounts are good for tracking most of the economics related to partnership operations.  But, certain economic items cannot be easily tracked with a capital account.  For those items, the capital account maintenance rules provide a different set of allocation rules.  For instance, tax credits cannot be easily tracked with a capital account, so the allocation of tax credits must be done according to special capital account maintenance rules for allocating tax credits.

Another partnership item that cannot be easily tracked with capital accounts are deductions and losses funded with third party debt.  We can show what we mean by losses funded with third party debt with a simple example.  Assume two partners form a partnership and they contribute no capital.  Next, assume the partnership borrows to acquire real estate.  If the partnership generates no income in the first year but the real estate provides $1,000 of depreciation, the $1,000 loss related to depreciation would have been funded by the lender.  And, if the depreciation is allocated to the partners under the normal capital account maintenance rules it would cause the capital accounts to become negative (i.e., because the capital accounts started at zero), which is not permitted.

The reason capital accounts are not permitted to become negative is that tax policy dictates that taxpayer’s are only permitted to deduct expenses or losses they have funded.  If a capital account was permitted to go negative, it would happen in situations where an expense or loss was funded by someone other than the member.  To address these issues, there is a complex set of rules under Treas. Reg. §1.704-2 designed to allocate deductions among partners where the deductions are funded by creditors.  These deductions are referred to as Nonrecourse Deductions and the related liability is referred to as a Nonrecourse Liability. In addition to Nonrecourse Deductions and Nonrecourse Liabilities, the rules for allocating these items require knowledge of the terms Minimum Gain and Minimum Gain Chargeback.  We discuss the definition of these terms in part 2 of this article.

The Liquidation Requirement

This requirement is straightforward.  To meet The Liquidation Requirement, an OA must state that liquidating distributions are made in accordance with the partners’ positive capital accounts.

The effect of requiring an LLC / partnership to maintain capital accounts and then requiring it to liquidate based on positive capital accounts is to ensure that each member receives only what they have economically invested, which includes the sum of (1) the value contributed, (2) plus/minus book profits /losses allocated to the member, and (3) minus distributions previously made to the member.  The end result is a strong correlation between the economic value contributed by a member (including income /loss allocated to a member) and distributions to a member.  This is the primary purpose for requiring allocations to have economic effect.

The Qualified Income Offset Requirement

According to the Safe Harbor Rules, an OA must contain a Qualified Income Offset provision.  An OA is considered to have a Qualified Income Offset where an allocation cannot cause or increase a deficit balance in a member’s capital account.  Further, an OA is considered to have a Qualified Income Offset only if it specifically provides that “a member who unexpectedly receives an adjustment, allocation, or distribution that creates a deficit balance…will be allocated items of income and gain…in an amount and manner sufficient to eliminate such deficit balance as quickly as possible (italics added).

The Qualified Income Offset provision has two requirements.  The first is that an allocation cannot cause or increase a deficit balance in a member’s capital account.  This is accomplished with the “Loss Limitation” provision that we will address in part 2 of this article.

In addition to the above, an OA agreement must specifically state that “a member who unexpectedly receives an adjustment, allocation, or distribution that creates a deficit balance …will be allocated items of income and gain…in an amount and manner sufficient to eliminate such deficit balance as quickly as possible.”

The purpose of the Qualified Income Offset provision is to ensure that a member’s capital account does not become negative. If a member was permitted to receive an allocation that caused his/her capital account to become negative, that member would have been allocated deductions in excess of what the member invested and has “at risk”.  This would violate tax policy geared towards ensuring that a taxpayer cannot obtain a loss or deduction in excess of what they have invested.

In part 2 of this article, we define and discuss the Tax Related Terms and provide additional information about The Alternate Test for economic effect.

Endnotes

[1] This article applies to (1) partnership agreements, and (2) operating agreements for limited liability companies treated as partnerships for tax purposes.  For simplicity though, we refer only to operating agreements.

[2]  An allocation that follows the Safe Harbor Rules may have the unwanted effect of disrupting the business deal of the parties.  This can happen with an OA that uses a waterfall allocation that follows the Safe Harbor Rules. For this reason, many choose a target allocation which often does not technically follow the Safe Harbor Rules but instead relies on the allocation being in accordance with the partner’s interest in the partnership.

Erik Lincoln is a founding member of Lincoln. In addition to being an attorney he is also a CPA. Erik has consistently been recognized as one of the top attorneys in North Carolina, by Business North Carolina.