Most will agree that the technical tax allocation sections of most partnership agreements or LLC operating agreements are just unreadable. No socially well-adjusted human being, and by that I mean a person who isn’t a tax lawyer, reads the endless paragraphs on “qualified income offset,” “partner nonrecourse minimum gain,” and “Section 705(a)(2)(B) expenditures” and derives any useful information about the parties’ business arrangement, which is the point of language in any contract.
Once upon a time, the now-familiar tax boilerplate was novel and useful. From the mid-70s through the early 90s, Congress and the IRS promulgated a wave of new laws and regulations to shut down individual tax shelters. Through nonrecourse loans and manipulations of partnership tax accounting, these shelters allowed taxpayers to claim large ordinary losses without having to actually lose money, and take cash distributions without recognizing taxable income. The resulting rules gave birth to terms like “substantial economic effect,” “minimum gain chargeback,” and “adjusted capital account deficit.”
It’s believed that William McKee and William Nelson first popularized long and descriptive recitations of the new tax regulations in the form agreements published with their famous treatise on partnership taxation. The rest of the bar soon followed suit, which one could blame on conformity, but there was an educational function, too — for lawyers, accountants, and clients alike.
With due respect for our forebears, I believe the novelty and usefulness of the long-form tax section has passed. A few million cut-and-pastes later, it’s just clutter. The forms often don’t get updated, and inaccuracies creep into the language and section references. Its lessons on using capital accounts and the need for allocations of income and deductions to have real-life economic consequences have become common sense. Other tax law innovations, such as the passive activity rules, have shut down individual tax shelters in their own right. Most of all, its regurgitation of the law is largely superfluous. How to calculate partnership minimum gain is governed by the regulations, regardless of what your agreement says. We don’t need 12 defined terms and 5 pages of agreement text to tell us what the law is.
Now, we can’t just chuck it all. Many necessary concepts only apply if “provided for in the partnership agreement,” so we must at least incorporate them by reference. And of course the central provision on how to allocate profits and losses is driven more by the business agreement than by law; it must be customized on a deal-by-deal basis.
So I’ve drawn up a new model of standard allocation provisions in the form of a hypothetical Article IV to an LLC operating agreement based on two guiding principles. First, shift as much ministerial detail to the tax regulations as possible. Second, when it comes to accounting choices, such as which method to use for Section 704(c) allocations, give the choice to management. When the choice becomes relevant, they can run the numbers and decide upon a mutually acceptable solution. You don’t trust management? Then pay attention to what’s discretionary, and either negotiate a choice ahead of time or settle upon a dispute resolution mechanism for making the choice later. But even with such customizations, I believe the new form is technically sound for tax lawyers, user-friendly for non-tax lawyers, and cost-effective for clients.
DISCLAIMER: I’m sharing my new form to let you know what I’m doing. Feel free to use or share, royalty-free, as my contribution to improving the practice of tax law. But I’m not (yet) your lawyer. Always have a tax attorney review your partnership or operating agreements. I’m just suggesting a way to make that review faster, cheaper, and less annoying. Enjoy.