What Your Attorney Doesn't Tell You About Operating Agreements

Being a part owner of a business can be a lifelong goal realized. You dream of being a partner, shareholder, or co-founder and when the day comes it can feel surreal.

But for too many first-time owners, the business operating agreement can be a source of uncertainty. Tossed in the drawer as a "check-the-box" document that was half-read and a quarter-understood.

To make things worse, many attorneys draft boilerplate provisions and kick the can to the CPA to review the tax sections. And most CPAs are not experts in operating agreement language — which is terrifying given the implications the language has on the actual business and tax filing.

When the Tax Court evaluates the legitimacy of business decisions, it usually starts with the operating agreement before going to case law. First and foremost stands the operating agreement for all things business and tax.

What Key Operating Agreement Terms Should Every Partner Know?

Every partner should understand capital accounts, classes of units, and deficit restoration obligations before signing. These defined terms control how income is allocated, how preferred returns are calculated, and whether you can receive losses beyond your cash investment — yet most partners never read them.

Most operating agreements start with defined terms. Read them. Understand them. Here are the major ones:

Capital Account — Critical in a partnership. But in an S-Corp? This term can imply a busted S-Election. S-Corps require pro-rata distributions. Capital account maintenance language suggests otherwise.

Classes of Units — Where your preferred return is defined. Confirm pref only applies to the correct class. Watch for terms like "guaranteed payment" and IRC 707(c) references.

Deficit Restoration Obligation — A mechanism that allows a partner with less than pro-rata capital to receive loss allocations in excess of their contributions. A powerful planning tool for strong deals, but it must be unconditional to be valid.

What Are the Two Types of Allocation Language?

The two allocation methods are Safe Harbor and Target Capital. Safe Harbor works for pro-rata deals with a promote and requires three specific provisions: capital account maintenance, a DRO or QIO, and liquidating distributions per positive capital accounts. Target Capital handles layered equity with varying unit classes.

Safe Harbor — The pro-rata method. When there's a promote, you need three key provisions: capital account maintenance, a DRO or QIO, and liquidating distributions in accordance with positive capital accounts.

Target Capital — Used when you have varying classes of units. Works by calculating how much of the ending balance sheet goes to which partners. Look for "hypothetical liquidation" language. Never appropriate for an S-Corp.

How Should the Operating Agreement Handle Profits Interests?

The operating agreement must explicitly reference Rev. Proc. 93-27 safe harbor compliance and confirm the profits interest has zero liquidation value at the date of grant. Without this language, the IRS can treat the grant as taxable compensation — turning a powerful planning tool into an unexpected income event.

When done correctly, profits interests are non-taxable at grant. The IRS safe harbor under Rev. Proc. 93-27 provides clear guidance, but most operating agreements omit the required language. The interest must have zero liquidation value at grant.

Why Are Mandated Tax Elections Dangerous in an Operating Agreement?

Operating agreements that mandate specific elections — such as requiring a Section 754 election or locking in accrual-basis accounting — remove professional judgment from the tax preparer. These decisions should be made year-by-year based on the partnership's actual circumstances, not locked into a legal document drafted before operations begin.

Operating agreements that mandate specific tax elections — like requiring a 754 election or locking in accrual basis — tie the hands of the tax preparer. These are judgment calls that should be left to the professional preparing the return.