Operating Agreements and Taxes: What You Need to Know
As you may have gathered from some of our previous articles (for example, read “Does your LLC have a proper Operating Agreement?” and “Important clauses for LLC Operating Agreements“), the Operating Agreement is the foundation of any limited liability company. If yours is missing a lot of key terms and conditions, or, even worse, if it contains terms and conditions you don’t want, your LLC could potentially collapse — costing you time, money, and wasted opportunity.
A company’s profits and losses pass through to the members automatically based on criteria spelled out in the Operating Agreement.
If you’ve followed us long enough, you might also know that an LLC can choose to be taxed as several other kinds of entities: disregarded entities, partnerships, Subchapter S Corporations (“S-Corps”), and Subchapter C Corporations (“C-Corps”). How you choose to have your LLC taxed has widespread ramifications on how regular business decisions get made. For example, if your LLC is taxed as a partnership, the company’s profits and losses pass through to the members automatically based on criteria spelled out in the Operating Agreement. You can customize the arrangement in any number of ways to benefit some partners over others so long as the arrangement has what the Internal Revenue Service considers “substantial economic effect”.
However, let’s say your LLC is taxed as an S-Corp. In that scenario, the profits and losses still pass through to the members automatically — but only in a proportional manner based on the percentage of the LLC owned by each member. Any non-proportional allocations or distributions put the LLC’s S-Corp status at risk and can have unintended — and usually very costly — consequences for the LLC. For more understanding of S Corps and their tax benefits read, “A S-Corporation may help you save a lot in taxes.“
Using the right Operating Agreements for your business
This is where your LLC’s Operating Agreement comes into play. Many new business owners don’t give much thought to their Operating Agreement and often rely on free templates found on the internet. It’s important to look closely at these templates to understand what you might be giving up, what you’re agreeing to, and what risks you’re taking on by using a document that may not be fit for purpose. For example, if you’ve decided to have your LLC taxed as an S-Corp and your Operating Agreement mentions “capital accounts”, “Code Section 704”, or “partners”, that document was drafted for an LLC taxed as a partnership. Most free templates found online are drafted for partnership-type LLCs. Using one for an LLC taxed as an S Corp can create contractual obligations between the LLC and its members that would jeopardize its S Corp status because, among other things, non-pro-rata distributions are forbidden in S-Corps. If the LLC’s S-Corp status is lost, it will revert to ‘C-Corp’ status and become subject to double taxation. That is, for most people, very undesirable.
Even more bizarre circumstances can arise when you use a partnership-type Operating Agreement for an LLC that has elected to be taxed as a Subchapter C Corporation (for more on these read, “Return of the C-Corporation“). C-Corps are distinct taxable entities in which the profits and losses do not pass through to the owners when the company receives them; the company itself pays taxes on its net business income and holds onto the money to either reinvest or pay out to the shareholders in the form of a dividend, at which point the owners separately pay taxes on the dividends they receive. As you might imagine, using a partnership-type Operating Agreement would guarantee the members allocations and distributions of net business income they may never receive, in a manner wholly contradictory to the way a C-Corp operates. This is a bit like filling your gas-powered car with diesel – there are only a few possible outcomes and they’re all bad.
How we can help
Fortunately, finding a good Operating Agreement that’s fit for purpose and designed around your business is easier than ever. Law 4 Small Business is proud to present the Couture Operating Agreement, and it’s available free to clients who form a LLC or Anonymous LLC with us. This tool will walk you through some of the most important (and often overlooked) decisions you need to make about your business and produce an operating agreement tailored to your needs and priorities. Our Operating Agreements are created with the most up-to-date business and tax laws in mind so you can confidently build your business on a rock solid foundation.