Top Ten Tax Issues To Be Careful of In LLC Agreements

My tax partner Nina Krauthamer and I work closely on LLC agreements.  I frequently hear the question:  "Why do I need a lawyer knowledgeable in income tax issues to review my LLC agreement?"  Nina's answer:

Tax considerations certainly play a part in any choice of entity for the small or medium size business owner.  LLCs often are used because LLCs offer corporate-type limited liability with the flow through tax treatment and flexibility of partnerships. 

Here are the top ten tax and economic issues that members of LLCs should consider when contemplating or negotiating an LLC structure:

1.  How will members and other service providers be compensated?  Are “salaries” contemplated - which are treated as so-called “guaranteed payments” under IRS rules?  Will service providers receive a share of future profits and gains - a so-called “profits interest”?

 2.  Do the tax allocations make sense in light of expected cash distributions?  What happens upon liquidation of the LLC?  Does the agreement have the effect of causing a current tax event for holders of a profits interest?

3.  Will members have a fixed percentage of profits, or will those percentages change depending on cash flows or other measurements?

4.  Which members will bear losses, particularly in the early years of the LLC, and will there be special allocations of losses and deductions?

5.  Will some members receive a “preferred return” on their investment, and if so, will there be a catch-up for other members?

6.  Who will be responsible for preparing tax returns and acting as the “tax matters partner”?

7.  Will income from the partnership be subject to self-employment taxes?

8.  Will the passive loss or at risk rules apply to an investment in the LLC?

9.  What state and local taxes will apply to the income of the LLC (e.g. New York City Unincorporated Business Income Tax)?  Will there be withholding on allocations to foreign (non U.S.) partners?

10.  Will an investment in the LLC cause a partner to be subject to income or estate taxes in the State where the LLC does business?

See Tax & Personal Planning, Joint Ventures & Strategic Alliances and Real Estate Joint Ventures for descriptions of our tax and corporate and real estate joint venture practices.

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