Tax Considerations to Include in Your Partnership or Shareholder Agreement

When drafting a partnership or shareholder agreement, don’t overlook one important aspect – tax considerations. An agreement that omits how a partner or shareholder gets taxed can lead to unintended tax liabilities, disputes, and financial setbacks. Here are several tax-related areas to include in your business’s agreement.

• Clear profit and loss allocation. If an agreement fails to specify how profits and losses should be divided among owners, or if it includes arbitrary allocations without a justification, the IRS may reallocate income in a way that increases the tax bill for certain owners.

For example, if a partnership agreement states that profits will be split equally but losses will be disproportionately allocated to one partner, the IRS may challenge this allocation as lacking substantial economic effect. If the IRS recharacterizes the allocations, some partners may face unexpected tax liabilities.

• Distribution clause to address tax obligations. Without a tax distribution clause, partners and shareholders may find themselves responsible for taxes on income for which they never received in cash. This situation can create financial strain, especially for minority owners who lack control over how distribution decisions are made. So consider including a tax distribution provision in your agreement to ensure that owners receive enough cash to cover their tax liabilities.
• Clarity on buy-sell provisions upon death, disability, retirement, or exit. A buyout could trigger unexpected capital gains taxes or ordinary income treatment at higher tax rates, or cause the IRS to deem certain buyouts as disguised compensation. Structuring buyout provisions carefully can possibly mitigate these risks.
• Clear debt allocation. For partnerships, the allocation of liabilities among partners affects their tax basis, which in turn determines their ability to deduct losses. If a partnership agreement does not specify how debt is allocated, partners may unexpectedly lose the ability to deduct losses or face additional tax liability if debt is reclassified.
• Continuity of S corporation status. For S corporations, shareholder agreements must comply with strict IRS requirements to maintain S-corp status. If an agreement allows ineligible shareholders (such as partnerships, corporations, or non-resident aliens) to acquire shares, the S corporation could lose its pass-through tax treatment and be subject to corporate tax at the entity level.

A partnership or shareholder agreement that’s written without tax considerations can have major tax consequences. Please call if you have tax-related questions about your business’s agreement.