Con­sider us­ing at­tor­ney to set up part­ner­ship

Albuquerque Journal - - BUSINESS OUTLOOK - Jim Hamill Jim Hamill is the direc­tor of Tax Prac­tice at Reynolds, Hix & Co. in Al­bu­querque. He can be reached at [email protected]

Q: I am draft­ing an agree­ment for a part­ner­ship that I am form­ing with three friends to buy rental prop­er­ties. We hope to end up with 10-12 prop­er­ties as part of our re­tire­ment plan­ning be­cause the stock mar­ket is just too un­cer­tain. We will each con­trib­ute one-fourth of the in­vestor cap­i­tal, be re­spon­si­ble for one­fourth of the debt, and will share all prof­its, and any losses, one­fourth each. We are in the process of set­ting up an LLC to op­er­ate the busi­ness. Ev­ery­thing seems pretty ba­sic ex­cept for one taxre­lated thing. One of the part­ners says that we need to pro­vide for “tax dis­tri­bu­tions” each quar­ter so ev­ery­one can pay taxes on their share of the in­come from this part­ner­ship. I have no prob­lem with this sug­ges­tion but am un­sure how it should be phrased in the agree­ment. Any ideas?

It does sound like you have a fairly sim­ple part­ner­ship, as part­ner­ships go. And since you are a part­ner you can draft the agree­ment even with­out be­ing a mem­ber of the state bar.

None­the­less, I would ad­vise you to hire an ex­pe­ri­enced at­tor­ney who has dealt with real es­tate part­ner­ships be­fore. You have brought up one is­sue that can be dif­fi­cult to draft but there are oth­ers that also need to be con­sid­ered.

Be­cause the eco­nomics of the deal are sim­ple, I think you can get le­gal help with­out pay­ing an arm and a leg. I doubt you would even pay a king’s ran­som or a small for­tune.

Like any CPA, I have seen many friend­ships de­volve into some­thing that can­not be de­scribed in po­lite con­ver­sa­tion once a busi­ness ven­ture is started. A part­ner­ship agree­ment should deal with po­ten­tial fu­ture con­flicts.

With the ser­mon over, let me ad­dress some of the is­sues in a tax dis­tri­bu­tion clause. The pur­pose of a tax dis­tri­bu­tion, as you men­tion, is to al­low part­ners to pay tax on their share of the part­ner­ship in­come. This in­come is taxed to them whether dis­trib­uted or not.

Tax clauses can be very chal­leng­ing to draft. The first thing the four of you need to de­cide is how com­plex you want this pro­vi­sion to be.

A sim­ple clause would say that each mem­ber will get a dis­tri­bu­tion equal to a fixed per­cent­age of the in­come. For ex­am­ple, you of­ten see terms like 40 per­cent of the in­come.

Be­cause you know each part­ner, you should be a bit more pre­cise on the rate. For ex­am­ple, the fed­eral rate for tax­able in­come of a mar­ried per­son is 22 per­cent from $77,400 up to $165,000 of tax­able in­come. So you could use a rate of, say 27 per­cent to cover fed­eral and state taxes.

You also need to de­cide if tax dis­tri­bu­tions are manda­tory or dis­cre­tionary. I rec­om­mend dis­cre­tionary be­cause it may be that the part­ner­ship lacks read­ily avail­able cash flow. If dis­cre­tionary you need to de­cide who makes the dis­tri­bu­tion de­ci­sion.

You also need to de­cide if dis­tri­bu­tions will be quar­terly, which is when es­ti­mated taxes are due, or an­nual. Spe­cific dates should be pro­vided in ei­ther case.

Tax dis­tri­bu­tions are al­most al­ways con­sid­ered to be ad­vance draws against “reg­u­lar” dis­tri­bu­tions to be made each year. So, it is im­por­tant to state that any tax dis­tri­bu­tions re­duce other dis­tri­bu­tions called for in the agree­ment.

You can get more com­pli­cated by con­sid­er­ing the type of in­come re­ported. For ex­am­ple if one of the prop­er­ties is sold and cre­ates a cap­i­tal gain, the tax rates, both fed­eral and state, are lower than for other sources of in­come. The tax dis­tri­bu­tion could then be at a lower rate.

You could also de­cide to have dif­fer­ent rates for part­ners liv­ing in dif­fer­ent states. This can get com­pli­cated be­cause in­come may be taxed in two ju­ris­dic­tions with a credit al­lowed in the res­i­dent state.

You may also want to con­sider that part­ners may change or one of the in­di­vid­u­als may trans­fer his or her in­ter­est to an­other type of tax­payer. The rate used to com­pute the dis­tri­bu­tions may be based on the type of part­ner.

A lot of this is, ad­mit­tedly, a bit overkill. But they are is­sues to con­sider. But the pur­pose of an agree­ment is to try to avoid prob­lems in the fu­ture.

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