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I seem to be reviewing a lot of partnership agreements lately. The tax provisions contained in these agreements are vital and can sometimes be overlooked. Most people think a partnership agreement just allocates profit and loss, but there is so much more to it than that. I thought it would be good to go over a few basic items when looking at the tax provisions in an operating agreement.

Here are some of the key tax provisions a partnership operating agreement should contain and why they should be in the agreement.

The tax classification of the partnership. That is, whether it will be taxed as a partnership/LLC, a C corporation or an S corporation. Sometimes state law will dictate the type of entity (partnership or corporation), but federal tax law will determine how it is taxed. The type of entity can be as much a legal question as a tax question. However, because of flexibility, most people opt for a limited liability company (partnership).

The allocation of profits and losses among the members. This is how the income and losses of the partnership will be divided and reported by the members for tax purposes. In an operating entity, the profit and loss percentage can be different from the capital (ownership). If one party does more work, he or she may be allocated a higher percentage of the profits/losses to reward them. This also can be done through guaranteed payments if you want the profits/losses to mirror ownership. In a passive partnership, such as a land rental entity, it might be difficult to justify one person getting a higher percentage of profits/losses than his or her ownership.

As a side note to allocation of profits and losses based off ownership percentage, in a partnership, you can have multiple classes of units (an S corp can't have more than one class of stock with different economic rights). This might be beneficial if one owner puts in a significant amount of money compared to the rest and wants a rate of return. He can have a preferred class of units that give him the first X% of profits or X% rate of return based on his capital contribution before the rest of the profits are split based on ownership.

Another provision is the distribution of cash and property among the members: how and when the partnership will make payments or transfers of assets to the members and how they will be taxed. Typically, a partnership will be required to make tax distributions. That way owners will have the cash to pay taxes associated with partnership profits.

A complex provision(s) is the tax basis and capital accounts of the members. This is how the members' investment and ownership interest in the partnership will be tracked and adjusted for tax purposes. This gets into minimum gain charge-backs, qualified income offsets and 704 language that is too technical for this article. However, they are very important if you guaranteed debt (especially if not every owner guarantees the debt).

As you can see, a partnership agreement isn't boilerplate. Thought must be given to even the most basic partnership. I always suggest that you involve both your accountant and attorney in the process. It's better to do it right in the first place rather than have to go through a long, protracted legal battle when issues arise down the road.

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-- DTN Tax Columnist Rod Mauszycki, J.D., MBT, is a tax principal with CLA (CliftonLarsonAllen) in Minneapolis, Minnesota.

-- Read Rod's "Ask the Taxman" column at https://www.dtnpf.com/…

-- You may email Rod at taxman@dtn.com

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