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.

Many attorneys draft boilerplate provisions and defer the tax sections to the CPA. And most CPAs are not specialists in operating agreement language. That gap between the legal drafting and the tax preparation is where the real value of understanding your agreement lives.

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.

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

Capital Account — Critical in a partnership. In an S-Corp, this term can signal a classification issue. 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 should explicitly reference Rev. Proc. 93-27 safe harbor compliance and confirm the profits interest has zero liquidation value at the date of grant. This is what keeps a profits interest non-taxable at issuance.

When structured correctly, profits interests are non-taxable at grant. The IRS safe harbor under Rev. Proc. 93-27 provides clear guidance. The interest must have zero liquidation value at grant, and the operating agreement should reference compliance.

Should Your Operating Agreement Mandate Specific Tax Elections?

Tax elections like Section 754 or accrual-basis accounting are best evaluated year-by-year based on the partnership's actual circumstances. Building flexibility into the operating agreement lets the tax preparer make the right call at the right time.

Operating agreements that lock in specific tax elections take a year-by-year judgment call and make it permanent. A 754 election or accrual-basis requirement might make sense for year one and not for year five. Leave these decisions to the professional preparing the return.