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Tax Matters and Your Operating Agreement

Updated: May 21, 2022

Est. Reading: 2 minutes

When you start a partnership or an LLC structured as a partnership in Arizona, its conduct, management, and financial decisions are outlined in the operating agreement. While tax strategies may not be foremost in your mind when you’re getting the business off the ground, the decisions you make in this regard can have a financial impact on you and the other partners.

Partnerships and Tax Allocation

As entities, partnerships and LLCs are not taxpayers. IRC 704(a) states that their taxable income, loss, gains, and deductions are allocated to the partners, who include these items on their own tax returns. Each partner is accountable for their respective share, regardless of whether there has been a distribution of money or property. As a result, your income tax liability related to business transactions may exceed the distributions you receive in any given year.

Each partner’s distributive share is supposed to be determined by the partnership agreement. IRC 704(b) states that if income, loss, gain, credit, or deduction allocations are not addressed in the partnership agreement or have no substantial economic effect, they must follow the partners’ interests in the partnership rules.

Tax Matters and Your Operating Agreement

Substantial Economic Effect Explained

Under the Internal Revenue Code, a partnership or LLC taxed as a partnership can have a certain degree of flexibility regarding pass-through of income and loss. However, the IRS will not honor allocations that lack substantial economic effect. This means that partnership allocations must pass through to the partners who receive the corresponding benefit or economic burden. If the IRS determines that an allocation or allocations do not have substantial economic effects, it may reallocate income or losses.

The impact of the substantial economic effect regulations may be most visible when looking at a limited partnership or LLC. In the eyes of the IRS, certain allocations can lack substantial economic effect due to limited liability.  If you are considering special allocations within a partnership agreement, you should note that a safe harbor is provided and can be satisfied by the inclusion of certain provisions. For example:

  • Distribution Triggered Special Allocations: These provisions allocate gain and income to the partner to offset excess distributions received by the partner that would exceed the partner’s interest.
  • Non-recourse Debt Allocations: With these provisions, loss and deduction allocations to partners associated with non-recourse debt-financed properties must be substantial in economic effect. 

Speak with an Experienced Arizona Business Formation Attorney

If you’re starting a partnership or LLC, it is recommended that you and your colleagues contact a business and tax law attorney to draft your operating agreement and review the impact of any special allocations. If the IRS reallocates income, loss, gain or deductions, it can have negative individual income tax consequences for each partner. At Monahan Law Firm, we can provide the legal guidance needed to start your enterprise on solid ground. To schedule a consultation, call (623) 385-3190.

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Attorney Patrick Monahan

Patrick Monahan

Patrick Monahan is the managing partner of Monahan Law Firm, PLC. Patrick began his legal career practicing real estate, construction, and general business litigation.
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