It’s a common scenario. A client or non-tax attorney says:

“We’ve put together a new LLC/partnership agreement. It should be fine because we’ve used this same agreement on all of our deals. We just changed the distributions a little.”

That sounds simple enough. But in practice, this approach almost always creates tax issues—sometimes obvious, sometimes hidden, and sometimes only revealed years later when distributions or exit events occur.

What Can Go Wrong?

When distribution provisions are modified, even slightly, one of several things usually happens:

  • The tax allocation provisions no longer work.
  • The provisions work in different and unexpected ways. For example:
    • One or more members may have accelerated tax allocations at higher rates—sometimes without corresponding cash distributions.
    • Members may not actually be entitled to the liquidation distributions they expect.
  • A taxable capital shift occurs without any cash changing hands.
  • The expected holding periods for long-term capital gains are altered.
  • Or, in some cases, everything works as expected with no material unanticipated tax consequences.

The challenge is that you don’t know which bucket you’re in until someone with tax expertise reviews the agreement. Hoping you’re in the last category isn’t a strategy.

Why Contributions Complicate Things Further

These same issues often arise when new capital contributions are made to an existing LLC or partnership. Even if the original agreement contemplated future contributions, the operating and liquidation provisions may no longer function as intended.

This can also raise questions like:

  • Should the partnership “book-up” capital accounts to reflect current fair market values?
  • If so, will the book-up work the way the parties expect with the existing distribution waterfall?

Without careful review, the parties may be left with allocations and distributions that don’t match their business deal, or worse, that trigger unexpected tax liability.

The Takeaway

LLC and partnership agreements are not “one size fits all.” Seemingly minor adjustments, especially to distribution language, can create ripple effects across tax allocations, liquidation rights, and capital accounts.

Before finalizing or amending an agreement, it’s critical to have a tax professional review the provisions. The goal is to confirm you’re in the last category, where everything works as intended, rather than discovering the following tax season or worse years later that you’ve created an avoidable tax problem.

Contact:

Jeff Wallace I 713.650.2708 I [email protected]