In this episode, we're joined by Kaylyn Deaver, CPA, a Tax Manager here at The Real Estate CPA! We will discuss operating agreements, specifically the tax components of operating agreements, and why it's important that you have your CPA involved in the creation and review of the agreement.
Kaylyn specializes in large partnerships, syndicates, and funds, from 5 partners to 800 partners.
The operating agreement is the legal backbone of your entity. There's a lot of legal jargon with a few sections that are relied on heavily for tax purposes. Every entity needs an operating agreement, they are used to define the purpose of an entity and the powers of the entity. When a partnership is formed, a well-written OA leaves no room for confusion.
Even small entities with friends and family members should have operating agreements. Things can always go haywire and the operating agreement needs to be there to establish the situation and determine liability.
Classes of Ownership/Interest
In a larger partnership, there can be different classes of interest. It's generally Class A and Class B, with general partners in one class and limited partners in another class. The operating agreement separates the powers of these classes. One class of partners are generally actively managing the fund and may not always contribute capital. The other class of limited partners is usually passive and this group contributes the majority of the capital. Usually, the ownership is 80/20 or 70/30 in favor of the limited partners.
How do These Classes Affect Distributions?
We generally see two types of distributions. The first is a distribution of excess cash throughout the life of the partnership. The second distribution is the distribution of any remaining funds when the partnership liquidates. Both of these items will be spelled out in the operating agreement - it's important for GPs to be very specific and for LPs to really know what's in the OA and when you're entitled to cash.
"Throughout the life of the partnership, the distributions can be as simple as a 70/30 split of any excess cash split between LPs/GPs, or the agreements can be more complex and have a stated preferred return outlined. We see preferred returns pretty frequently in partnerships that deal with real estate."
We will talk more about these preferred returns in a future episode.
Distributions at Liquidation
At the end of the partnership, we generally see the operating agreement spell out distributions in order of class. In tax terms, we call this a waterfall allocation. First, there's generally a return of capital to the LPs. Second, any accrued preferred returns are paid. Third, any accrued preferred returns are paid to GPs. Fourth is the final allocation of any remaining profits. The final allocation can also be multiple steps divided between GPs and LPs.
"It's important for GPs to be really clear so LPs know exactly what to expect."
It's a wise idea to have a CPA review your operating agreement before finalizing and signing. It takes multiple eyes and brains to properly put together an operating agreement.
What to Look For as an LP?
In addition to understanding the distributions during operation and the waterfall allocation at the close of the partnership, it's important for LPs to know when their original capital contribution will be returned. This could be a specific date, a certain IRR, or upon the refinance or sale of a property.
LPs should also look for additional capital calls. It's possible that LPs may be called upon for additional cash during the deal.
"One of the greatest aspects of a partnership is the flexibility offered in allocations. Code Section 704 allows partnerships to make special allocations of income and loss. Special allocations restructure the method in which your profits and losses are distributed to partners in a way that doesn't correspond to the percentage interest in the partnership."
Generally, special allocations are unintentionally somewhat hidden. This can be outlined in a different section from the other profit and loss allocation sections. Special allocations can even be an amendment to the OA.
Bonus depreciation is a common special allocation. Another allocation is a special allocation of profit in lieu of a preferred return. The IRS generally applies greater scrutiny to special allocations because they deviate from the standard treatment.
"If you are making special allocations, it is extremely important to loop in a CPA to make sure your special allocations have a substantial economic effect."
Why Should I Care?
It's estimated that less than 30% of CPAs can properly dissect an OA and apply Section 704. Section 704 may be the most complex section of the tax code.
"Considering that attorneys use templates and rely on CPAs to interpret and apply what the operating agreement contains, it's extremely easy for a partnership to have an operating agreement that doesn't match its intentions or it's misapplied at tax time. It's important to truly clarify what's intended for the economic structure of your partnership."
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