When was the last time you reviewed your business’ operating agreement? If you are a limited liability company (LLC) or partnership, there are some recent rule changes from the IRS that may be harmful to you and your partners. But with the right planning and some revisions in your operating agreement, you can make the rules work to your benefit!
Along with tax reform came new rules for “small businesses” – those with average annual gross receipts under $25M – but those rules have a catch. The new rules only apply to companies that are not a “tax shelter.” Suddenly, CPAs and partnerships began to take more notice of the definition of a tax shelter. And while it has been in the code for decades, there is surprising little guidance about one of the broadest definitions: a business is a tax shelter when 35 percent or more of a loss is allocated to a “non-active” partner, also known as limited partner (LP) or limited entrepreneur (LE). In other words, all the rules tied to companies with annual gross receipts exceeding $25 million will work against you because you can now be deemed a tax shelter, even if your gross receipts are under $25 million!
What’s at Risk?
Let’s say you and your partner are 50/50 owners in a cash-basis business. If your non-active partner is allocated 50 percent of the loss in any year, your company will be deemed a tax shelter. That means it can no longer use the cash method of accounting, may be subject to the new interest expense limitations, may need to continue with uniform capitalization rules and more.
The Solution? Flexibility in Operating Agreements
As it stands, if you have a loss year and your company has become a tax shelter, you’ll encounter the consequences stated above.
As a partnership or LLC taxed as a partnership, you are allowed to make special allocations, or disproportionate allocations, if your operating agreement allows it. The new tax shelter definition makes it vitally important to consider flexibility in drafting your operating agreement so that you can allocate losses and profits in a more beneficial manner.
Your operating agreement should allow for flexibility so that in a year of loss, the loss will be allocated to the active manager or managers. In a subsequent year of profit, you could allocate the profit in the same way to make up for the amount of loss previously allocated. When you allow for special allocations, you are able to legally circumvent the negative impact of the new tax shelter rules.
Make changes to your operating agreement in a holistic way. As you make adjustments for the centralized partnership audit rules, you’ll want to be sure your operating agreement is being updated for the 2018 tax year in a flexible manner that allows you to avoid the negative effects of the new tax code.