Consider using attorney to set up partnership

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.