Start here: how the company is taxed
Is the company taxed as a partnership or as an S corporation, and does the agreement match?
Where to find it: The tax classification clause, if there is one, and the company’s filing history.
What it does
Every other area depends on this answer. A partnership can use capital accounts, special allocations and a distribution waterfall. An S corporation cannot. Its shares must carry identical rights to distributions and liquidation proceeds, and the regulations look at the operating agreement to decide whether they do. LLCs are often formed with a partnership-style agreement, elect S status later, and never update the agreement.
What to look for
- A tax classification clause that states how the company intends to be taxed.
- Whether anyone has filed an S election (Form 2553) or an entity classification election (Form 8832). The agreement may not say, so ask.
- In an LLC taxed as an S corporation: preferred returns, classes of units with different payout rights, liquidation by capital accounts, or special allocations. Each one can create a second class of stock.
- In an LLC taxed as a partnership: whether the agreement was written when the company had one member, and whether any member is a trust or disregarded entity.
6.1 Distributions. Available Cash shall be distributed first to the Class A Members until each has received an amount equal to eight percent (8%) per annum on its Capital Contribution, and thereafter to all Members pro rata.
Effect on the return and K-1s
A partnership files Form 1065, and the K-1s follow the agreement’s allocation provisions. An S corporation files Form 1120-S, and income is shared strictly by shares owned per day. If an S corporation’s agreement gives owners different distribution rights, the election can terminate and the company is taxed as a C corporation from that date. Relief is available in some cases, and it is easier to get when the problem is found early.
Questions to ask
- Has the company filed an S election or an entity classification election?
- If it is an S corporation, has the agreement been checked for terms that give owners different distribution or liquidation rights?
Authority Reg. 301.7701-3; §1361(b)(1)(D); Reg. 1.1361-1(l)(2); §1362(d)(2); §1362(f); §1377(a)
Area 1: Allocation method
Which method does the agreement use to allocate income and loss, and does the language support it?
Where to find it: The allocations article and the definitions.
What it does
The allocation method is the set of rules the tax preparer follows to split income, gain, loss and deduction among the members. Agreements use one of two approaches, and a third applies by default. Layered allocations, often called safe harbor allocations, assign items by stated percentages or tiers and rely on the capital account rules in the regulations. Target allocations work backward from the waterfall: each year, items are allocated so each member’s capital account equals what the member would receive if the company sold everything at book value and liquidated. If neither holds up, the IRS allocates under the partners’ interest in the partnership standard, a facts-and-circumstances test that nobody chooses on purpose.
What to look for
- Safe harbor signals: capital accounts maintained under Reg. 1.704-1(b)(2)(iv), liquidation by positive capital account balances, and a deficit restoration obligation or qualified income offset.
- Target signals: defined terms such as Target Capital Account or Partially Adjusted Capital Account, and a hypothetical sale of all assets at book value.
- Whether the method fits the deal. A multi-tier waterfall paired with simple percentage allocations is the most common mismatch.
5.1 Allocations. Net Profits and Net Losses for each Fiscal Year shall be allocated among the Members in proportion to their Percentage Interests.
Effect on the return and K-1s
Every number on every K-1 comes from this section. When the method does not fit the waterfall, capital accounts drift away from what members will actually receive. The gap usually surfaces in the sale year, when gain has to be allocated to fix years of drift. Sometimes there is not enough gain to do it.
Questions to ask
- Which allocation method is this agreement written to use?
- Will the method produce capital accounts that match the waterfall at sale?
Authority §704(a) and (b); Reg. 1.704-1(b)(2); Reg. 1.704-1(b)(3)
Area 2: Safe harbor language
Does the agreement contain the three provisions the regulations require for the allocations to be respected?
Where to find it: The capital accounts section, the allocations article and the dissolution article.
What it does
The regulations give a bright-line test for allocations to have economic effect. The agreement needs three provisions, and they work as a unit. Capital accounts track each member’s economic stake. Liquidating distributions follow those capital accounts, which ties the tax allocations to the cash. A deficit restoration obligation or a qualified income offset deals with a member whose capital account goes negative. When all three are present and the allocations are also substantial, the IRS respects them, even when they differ from ownership percentages.
What to look for
- Capital account maintenance. Capital accounts are kept in accordance with Reg. 1.704-1(b)(2)(iv), and the agreement says so directly. Contributions and allocated income increase the account. Distributions and allocated losses decrease it.
- Liquidating distributions in accordance with positive capital account balances. When the company liquidates, cash goes out based on what each member’s capital account says.
- A deficit restoration obligation (DRO) or a qualified income offset (QIO). A DRO requires a member to restore a negative capital account in cash at liquidation. A QIO instead allocates income to a member whose account unexpectedly goes negative, with no personal liability. Most modern agreements use a QIO.
- All three in the same agreement. If one is missing, the allocations no longer qualify for the safe harbor.
11.3 Liquidation. Upon dissolution, after payment of the Company’s debts, the remaining proceeds shall be distributed to the Members in accordance with Section 6.2.
Effect on the return and K-1s
When all three provisions are present, the allocations are respected on exam. When one is missing, the allocations are tested under the economic effect equivalence rule or the partners’ interest in the partnership standard, and the support has to come from the facts. The most common gap is the liquidation provision: the agreement maintains capital accounts and includes a QIO, but liquidates through the waterfall.
Questions to ask
- Does the agreement include all three: capital account maintenance, liquidation by positive capital accounts, and a DRO or QIO?
- If there is a DRO, does every member know they may have to write a check at liquidation?
Authority Reg. 1.704-1(b)(2)(ii)(b) and (d); Reg. 1.704-1(b)(2)(iv); Reg. 1.704-1(b)(2)(iii); Reg. 1.704-1(b)(2)(ii)(i); Reg. 1.704-1(b)(3)
Area 3: Target capital mechanics
If the agreement uses target allocations, does it say what happens when net income or loss cannot reach the targets?
Where to find it: The allocations article and the definitions of Target Capital Account, Gross Asset Value and Book Value.
What it does
Each year, the preparer runs a hypothetical liquidation: sell every asset at book value, pay the debts, and run the cash through the waterfall. What each member would receive, adjusted for their share of minimum gain, is that member’s target. Income and loss are then allocated to move each capital account to its target. The method handles complex waterfalls well. It also depends on details that drafts often leave out.
What to look for
- A precise definition of the target, including the adjustments for minimum gain and partner minimum gain.
- Authority to allocate items of gross income or gross deduction when net income or loss cannot reach the targets.
- What happens in loss years after capital accounts reach zero, and which class absorbs losses first.
- Whether accrued but unpaid preferred return is part of the target. If it is, investors can be allocated income they have not received in cash.
- When assets are revalued, since targets are measured at book value.
- A statement that regulatory allocations come first and targets are applied after them.
- Enough flexibility in the sale year to bring every capital account to its target.
5.1 Allocations. Net Profits and Net Losses shall be allocated among the Members so as to cause each Member’s Capital Account to equal, as nearly as possible, its Target Capital Account.
Effect on the return and K-1s
Allocations change every year with the waterfall, so K-1 percentages move even when ownership does not. Investors can be allocated income for an accrued pref with no cash attached, and the sponsor can be allocated income for a promote before it is paid. There is no regulatory safe harbor for target allocations, so they are tested under the partners’ interest in the partnership standard and the economic effect equivalence rule. Clear drafting and annual workpapers are the support.
Questions to ask
- Who prepares the target calculation each year, and from what book values?
- Can the preparer allocate gross items when net items fall short?
Authority Reg. 1.704-1(b)(3); Reg. 1.704-1(b)(2)(ii)(i); Reg. 1.704-2; Reg. 1.704-1(b)(2)(iv)(f)
Area 4: Preferred return
Is the preferred return a share of profits, or a payment for the use of capital?
Where to find it: The distributions article and the definitions of Preferred Return and Unreturned Capital.
What it does
A preferred return gives investors priority on cash, usually a stated percentage of their unreturned capital. How it is taxed depends on the words. If it is paid from available cash and backed by allocations of the company’s income, it is a share of profits and carries the character of that income. If it is owed regardless of how the company performs, it can be a guaranteed payment for the use of capital, which is ordinary income to the investor and a deduction for the company.
What to look for
- Whether the pref is paid only from available cash and sale proceeds, or owed regardless of results.
- Phrases such as “whether or not the Company has net profits” or “guaranteed“.
- Whether it accrues, compounds and is cumulative, and the base it is computed on.
- Whether income is specifically allocated to match the pref, and what happens in a year without enough income.
- In an S corporation, any preferred return at all. See Start here.
4.2 Preferred Return. Each Class A Member shall accrue a preferred return of eight percent (8%) per annum on its Unreturned Capital, payable whether or not the Company has net profits for such year.
Effect on the return and K-1s
As a share of profits, the pref shows up in the regular income boxes of the K-1 and can include capital gain at sale. As a guaranteed payment, it is reported separately as ordinary income, and the company’s deduction reduces the income allocated to everyone else, including the sponsor. Under target allocations, an accrued pref can be taxed before it is paid.
Questions to ask
- Is the pref meant to be paid only from cash flow and sale proceeds?
- In a loss year, what is the investor owed, and when?
Authority §707(c); Reg. 1.707-1(c); §704(b)
Area 5: Distribution waterfall
Do the cash waterfall and the tax allocations end in the same place?
Where to find it: The distributions article, often with separate sections for operating cash and capital transactions.
What it does
The waterfall decides who gets cash and in what order. A typical real estate waterfall returns capital, pays the preferred return, gives the sponsor a catch-up, then splits what is left. The allocation provisions decide who is taxed. Over the life of the deal, the two should end in the same place. When they do not, someone is taxed on money that goes to someone else.
What to look for
- Separate waterfalls for operating cash and for sales or refinancings, and whether the allocations work under both.
- Exact tier math: simple or compounding pref, IRR or equity multiple hurdles, and how the catch-up is computed.
- For IRR hurdles: the compounding method, the dates used, and whether tax distributions count as distributions.
- Clawback or lookback provisions, and how a sponsor’s repayment would be taxed.
- Whether promote can be paid from a refinancing before a sale.
6.2(c) Residual Split. Thereafter, seventy percent (70%) to the Class A Members and thirty percent (30%) to the Manager, provided the Class A Members have achieved an internal rate of return of fourteen percent (14%).
Effect on the return and K-1s
Under target allocations the waterfall drives every allocation, so ambiguity in the waterfall becomes ambiguity on the K-1s. Under layered allocations, a waterfall that departs from the allocation percentages leaves capital accounts that do not match the cash, and the difference has to be fixed at sale.
Questions to ask
- How is the IRR calculated, and do tax distributions count?
- Can the sponsor receive promote from a refinancing, and is any of it subject to clawback?
Authority §704(b); Reg. 1.704-1(b)(2)(iv); Reg. 1.704-1(b)(3)
Area 6: Debt allocations
Who gets basis from the loans, and does it line up with who gets the losses?
Where to find it: The allocations article, any guarantee or indemnity provisions, and the loan documents.
What it does
A member’s share of company debt adds to the member’s basis, and basis limits how much loss a member can deduct. Recourse debt, where a member bears the risk through a guarantee or otherwise, goes to that member. Nonrecourse debt, where no member is personally liable, is usually shared in proportion to the members’ profit-sharing ratios, and the agreement can state the ratio to use. In leveraged real estate, debt is often most of each investor’s basis.
What to look for
- A stated ratio for sharing nonrecourse debt, usually the members’ profit-sharing ratios, consistent with how profits are allocated.
- Which members guarantee which loans. Carve-out guarantees, often called bad-boy guarantees, generally do not shift debt until triggered.
- Indemnity or contribution agreements among guarantors, which change who bears the risk.
- Loans from members to the company, which create partner nonrecourse debt and their own deduction rules.
5.4 Nonrecourse Liabilities. Excess Nonrecourse Liabilities shall be allocated among the Members in accordance with their Percentage Interests.
Effect on the return and K-1s
Debt shares appear on each K-1 as the member’s share of liabilities. If debt is allocated away from the members taking losses, those losses can be suspended for lack of basis. A guarantee by the sponsor can pull debt, and the basis that comes with it, away from investors.
Questions to ask
- Is anyone personally guaranteeing a loan, and is there an agreement among the guarantors?
- Are any loans made by members?
Authority §752; Reg. 1.752-2; Reg. 1.752-3(a)(3); Reg. 1.704-2(i); §704(d)
Area 7: Profits interest and promote
Does the sponsor’s interest avoid tax when it is granted, and is the promote defined clearly?
Where to find it: The capital and units article, the waterfall, and any incentive or carried interest provisions.
What it does
A profits interest gives the holder a share of future profits and growth, with no claim on value that exists when it is granted. If the company liquidated on the grant date, the holder would get nothing. Under IRS guidance, receiving a profits interest for services is generally not taxable. A capital interest, which does share in existing value, is taxable as compensation when received.
What to look for
- A revaluation (book-up) of company assets at the grant, so existing members’ capital accounts hold the existing value.
- A distribution threshold or hurdle, so the new class shares only in value created after the grant.
- How the grant describes what the holder gave for the interest. A common red flag is language that issues the interest as consideration for services already rendered. That wording can suggest the grant is compensation for past work, which may make it taxable.
- Vesting and forfeiture terms, and whether holders are treated as members from the grant date. Many holders file a protective 83(b) election.
- The exceptions to the safe harbor. It does not cover an interest disposed of within two years of the grant, or an interest tied to a substantially certain and predictable stream of income, such as income from a high-quality net lease.
- Fee waivers, where the sponsor gives up a fee in exchange for more promote.
- Sale timing. Under section 1061, long-term capital gain allocated to a promote on assets held three years or less can be recharacterized as short-term. Gain from the company’s sale of section 1231 property, which includes most rental real estate, is excluded.
3.4 Class B Units. The Manager shall be issued 1,000 Class B Units, which shall share in all distributions pro rata with the Class A Units.
Effect on the return and K-1s
A properly drafted profits interest produces no income at grant, and the holder is taxed on allocations as the company earns them. A capital interest produces ordinary income at grant equal to its value, often with no cash to pay the tax. At sale, capital gain allocated to the promote may be taxed as short-term if the three-year holding period is not met, unless the gain comes from section 1231 property such as rental real estate.
Questions to ask
- Were the company’s assets revalued when the profits interest was granted?
- If the company sold everything the day after the grant, what would the holder receive?
Authority Rev. Proc. 93-27; Rev. Proc. 2001-43; §83; Reg. 1.721-1(b)(1); §1061; Reg. 1.1061-4(b)(7)(i); Reg. 1.704-1(b)(2)(iv)(f)(5)(iii)
Area 8: Tax distributions
Will members receive cash to pay tax on the income allocated to them?
Where to find it: The distributions article, usually a separate tax distributions section.
What it does
Members are taxed on income when it is allocated, whether or not they receive cash. A tax distribution clause requires the company to distribute enough to cover an assumed tax on that income. It matters most when income and cash fall out of step: loan principal paid from operations, accrued preferred returns, investors who sit behind others in the waterfall, and the sale year.
What to look for
- Whether distributions are required (“shall“) or left to the manager (“may“).
- The assumed tax rate, and whether it reflects the character of the income and state tax.
- Whether the calculation is cumulative, so prior losses reduce the amount.
- Timing. Quarterly distributions line up with estimated tax payments, but they are onerous to calculate and can drain cash: a profitable quarter triggers a distribution even if the next quarter is a loss. Consider allowing annual tax distributions.
- Whether tax distributions are advances against later waterfall distributions.
- What happens when cash is short or a lender restricts distributions.
- Whether holders of a profits interest receive them too.
4.4 Discretionary Distributions. The Manager may, in its sole discretion, distribute Available Cash at such times and in such amounts as it determines.
Effect on the return and K-1s
Tax distributions do not change anyone’s taxable income. They decide whether members can pay the tax on it. When they are treated as advances, they also reduce later waterfall distributions, which the waterfall and any target calculation have to account for.
Questions to ask
- Are tax distributions required, and at what assumed rate?
- Do they count as advances against later distributions?
Authority §701; §702; §704; §706(a); §731
Area 9: Sponsor fees
How will each fee be taxed to the sponsor and treated on the company’s return?
Where to find it: The fees or compensation section, any management agreements, and the use of proceeds in the offering documents.
What it does
Real estate deals pay sponsors acquisition, asset management, construction management, financing and disposition fees. The tax treatment depends on what the fee is for and the capacity in which the sponsor receives it. A fee to a member acting as a member can be a guaranteed payment. A fee under a separate agreement, for services as an outsider, is a payment to a service provider. Either way, the company may have to capitalize the cost.
What to look for
- Each fee, its base, when it is earned and when it is paid.
- Whether it is paid under this agreement or a separate management agreement, and to the sponsor or an affiliate.
- Acquisition fees, which are generally added to the property’s basis.
- Financing fees, which are amortized over the term of the loan.
- Costs of raising capital, which are syndication costs and cannot be deducted or amortized.
- Options to take a fee as units or as extra promote, which can be treated as a disguised payment for services.
- Whether fees come off the top or count toward the sponsor’s return in the waterfall.
7.2 Acquisition Fee. At Closing, the Company shall pay the Manager an acquisition fee equal to two percent (2%) of the Purchase Price, which the Manager may elect to receive as additional Class B Units.
Effect on the return and K-1s
Fees are ordinary income to the sponsor and may be subject to self-employment tax. On the company’s side, a fee can be deducted, added to the property’s basis, amortized, or never recovered as a syndication cost. Investors feel the difference through their share of deductions.
Questions to ask
- Is each fee paid under this agreement or under a separate management agreement?
- Can the sponsor convert a fee into units or promote?
Authority §707(a); §707(a)(2)(A); §707(c); §709; §263(a); Reg. 1.263(a)-2(f); Reg. 1.263(a)-5(a)(9); Reg. 1.446-5
Area 10: Partnership representative
Who speaks for the company in an IRS exam, and what limits does the agreement place on that person?
Where to find it: The partnership representative or tax matters section, usually in the tax article.
What it does
Under the centralized audit rules, the partnership representative has sole authority to deal with the IRS and binds the company and every member. The IRS can assess tax at the company level, so members who join later can bear tax from years before they arrived. Smaller companies with only eligible members can elect out of these rules each year. The agreement is the only place to add guardrails.
What to look for
- The named representative, and a designated individual if the representative is an entity.
- Whether the company will elect out each year, and whether it is eligible: 100 or fewer members, counting each shareholder of an S corporation member, all of them individuals, C corporations, S corporations, certain foreign entities or estates of deceased members. A member that is a partnership, trust or disregarded entity makes the company ineligible.
- Duties to notify members of IRS contact and to consult them before settling.
- Whether the representative will push adjustments out to the members from the year under exam.
- Authority to file an administrative adjustment request (AAR) to correct a filed return, since a partnership under these rules generally cannot file an amended return, and to push the resulting adjustments out to the members from that year.
- Cooperation duties for former members, and whether they survive an exit.
- Who bears an imputed underpayment, with indemnities between current and former members.
- How the representative is removed and replaced.
9.1 Partnership Representative. The Manager is hereby designated as the Partnership Representative of the Company.
Effect on the return and K-1s
If an exam results in an imputed underpayment, the company pays it at the highest rate unless it is modified or pushed out. That cost reduces current members’ distributions, whether or not they were members in the year examined.
Questions to ask
- Will the company elect out of the centralized audit rules, and is it eligible?
- If the IRS adjusts a past year, who pays: the company or the members from that year?
Authority §6221(b); Reg. 301.6221(b)-1; §6223; Reg. 301.6223-1; §6225; §6226; §6227; Reg. 301.6227-2(c); Reg. 301.6227-3; §6031(b)
Area 11: Tax elections
Which elections does the agreement require, allow, or leave to one person’s discretion?
Where to find it: The tax article and the manager’s authority section.
What it does
Some elections shape members’ results for years. A section 754 election lets a member who buys or inherits an interest adjust their share of the company’s asset basis. An electing real property trade or business avoids the business interest limit but must use longer depreciation lives. Bonus depreciation and cost segregation decide how fast losses arrive. These decisions are usually better made each year with the tax preparer than fixed in the agreement. The agreement should say who makes them.
What to look for
- Who decides on elections, and whether the agreement leaves room for the tax preparer’s judgment each year.
- Section 754: whether the agreement mentions it, so a member who buys or inherits an interest can ask for it. The election applies to all later years unless the IRS consents to revoke it.
- Section 163(j): whether the company will elect to be a real property trade or business. The election is irrevocable.
- Bonus depreciation and cost segregation plans, and how they affect losses now and recapture later.
- The election out of the centralized audit rules. See area 10.
- Elections the agreement mandates. A required election can lock the company into a result that no longer fits by the time the return is prepared.
8.4 Tax Elections. The Manager, in consultation with the Company’s tax preparer, may make any tax election available to the Company, including an election under Section 754 of the Code.
Effect on the return and K-1s
On a sale or death, a 754 election adjusts basis for the buyer or heir only, reported on that member’s K-1. It also adjusts the company’s asset basis after certain distributions, which affects every member. The 163(j) election changes depreciation for every member for every later year, and property that must use the longer lives cannot take bonus depreciation. These are some of the hardest decisions in the agreement to reverse.
Questions to ask
- Will the company make a 754 election if a member sells or dies?
- Is cost segregation or bonus depreciation planned, and has anyone checked the business interest limit?
Authority §754; §743(b); §734(b); Reg. 1.754-1; §163(j)(7)(B); §168(g)(1)(F); §168(g)(8); §168(k)(2)(D); §168(k)(7)
Area 12: Transfers and liquidation
What happens to capital accounts and allocations when someone sells, dies, or the deal ends?
Where to find it: The transfer restrictions article and the dissolution and liquidation article.
What it does
When an interest changes hands, the buyer takes over the seller’s capital account, and the year’s income is split between them. The main question for the agreement is control: whether members can move or sell their interests without approval. When the deal ends, the agreement sets how final distributions are made. These provisions are rarely read until they are needed.
What to look for
- Whether members can transfer interests to entities they set up, such as an LLC or trust, without prior approval.
- Whether members can sell their interests to outsiders without prior approval, or need consent from the manager or other members.
- Transfers to trusts, partnerships or disregarded entities, which can end eligibility to elect out of the centralized audit rules.
- A statement that a transferee succeeds to the transferor’s capital account.
- Redemptions of a departing member, and how the payments are characterized.
- Liquidation by positive capital account balances (see area 2), and distributions of property in kind.
10.1 Transfers. A Member may Transfer all or any portion of its Interest to an Affiliate or to any other Person without the consent of the Manager or the other Members.
Effect on the return and K-1s
A transfer during the year splits that year’s income between seller and buyer on their K-1s. The default is an interim closing of the books. Proration is available with an agreement of the members, which can be a written statement signed when the transfer happens, so the operating agreement does not need to pick a method in advance. A seller’s gain can include ordinary income from depreciation recapture under section 751. Without a 754 election, a buyer can be taxed on gain that built up before they bought in.
Questions to ask
- Can a member transfer an interest to an entity they own, or sell it, without approval?
- Who has to consent to a transfer, and what happens to the capital account when one occurs?
Authority §706(d); Reg. 1.706-4; Reg. 1.704-1(b)(2)(iv)(l); §751; §743