April 2008 - Issues in Partnership Taxation and Buy-Sell Agreements

Issues in Partnership Taxation and Buy Sell Agreements

Since Limited Liability Companies (LLCs) were established by statute about 20 years ago, they have swept through the business world like a tidal wave, casting aside other forms of business organizations in their wake. Why is that? They are flexible and dynamic in terms of the types of transactions and types of business relationships that can be formed, while allowing for limited liability for the owners. The good news is that more and more LLCs are being formed every day, and they have become the preferred entity for business. The challenge is that federal tax law treats Limited Liability Companies as Partnerships.

As advisors, we know that good planning during the initial stages of entity formation is critical. This involves anticipating the formation of the entity, as well as planning for the voluntary or involuntary withdrawal of members from the entity, known as the Buy-Sell Agreement. These types of agreements have been around for decades, notably under corporate-type entities.

Significant tax consequences can impact persons who are entering into or withdrawing from a partnership or a LLC. Partnership tax law is rampant with tax traps and snares for various transactions. Disappearing basis, phantom income, deemed income, shifting basis and fictional sales are just a few of the horrors that await a client and his / her advisor.

A major challenge is that most lawyers, who draft these agreements and advise their clients on the entry into an LLC and the withdrawal of a member from an LLC, do not understand partnership tax law. Without a structural knowledge of tax law, it is often more difficult to ask the right question than to get the right answer. Yet Buy-Sell Agreements are put into effect everyday, and often advisors and clients are unaware of the tax consequences.

Consider:

How will the value of the interest be determined?
Will the introduction or withdrawal of a member result in taxation to the other members?
Will the new investor/service member be entitled to prior capital appreciation, goodwill, or earnings? If not, how will these interests be segregated?
Is the new partner bringing cash, property or skills to the table? How can the entity value these skills?
Will the partner or member be entitled to an extra allocation of depreciation attributed to existing property?
Will the investment result in a deemed termination of the existing partnership and a re- start of depreciation?
Do the other partners or members plan on distributing cash or assets to themselves as the result of this purchase?
Will the dissolution of the LLC result in the loss of tax basis and/or phantom income?

How can you assure your client, who is entering into a Buy-Sell Agreement, of the best tax consequence?

Engage the services of an experienced, knowledgeable Tax Attorney as part of your Client Service Team by using Robison Law Firm.

Stephen L. Robison is a full time, practicing tax attorney, who is a Board Certified Federal Tax Specialist since 2002. He is experienced in handling complex tax planning issues. Mr. Robison, and our team of professionals, will work with you and your clients to strategically assist your client's tax planning needs and minimize your risk of tax malpractice.