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One of the tax practitioner's most difficult tasks is drafting tax distribution provisions. Many often get them wrong. Sometimes they go a little wrong- and clients may then be forgiving. Some go badly wrong, and have resulted in many millions (or hundreds of millions) of dollars of cash that should have gone to one counsel's client going to some other counsel's clients. Doing this too often can lead to poor client relations- and perhaps no client relations at all. This article is dedicated to good client relations.
The tax distribution provision that will work in all situations does not exist. Each provision needs to be drafted to accommodate the needs of the particular partnership.
First priority distribution provisions
Partnership agreements frequently contain first priority tax distribution provisions. The draftsman of a partnership agreement often designs a tax distribution provision to ensure that each investor receives enough cash to pay the taxes on his or her distributive share of tax items from the partnership.1 Tax distribution provisions promise partners minimum distributions of cash flow so these partners can meet their tax obligations on their distributive shares of partnership income. Many draftsmen consider tax distribution provisions important tools- and among the most difficult provisions in the partnership agreement to draft.
Proposed Section 710, which has been introduced in both the House of Representatives and the Senate, would cause tax practitioners to rethink their partnership tax distribution provisions.2 Traditional tax distribution provisions might not work properly after the enactment of proposed Section 710.
Proposed Section 710 would:
* Increase tax rates on a portion of a service partner's distributive share from a partnership.3
* Tax the service partner at normal tax rates on his or her remaining distributive share.
* Create anomalies tor drafting tax distribution provisions.
* Potentially tax a partner at a higher tax rate than otherwise would apply.
* Potentially tax a partner on otherwise nontaxable partnership distributions.
Any income or loss treated as ordinary income under proposed Section 710 would be treated as self-employment income.
Separately, Congress increased the Medicare tax rate for individuals with incomes over $200,000 and couples with incomes over $250,000 to 3.8%, effective for tax years after 2012. 4
Priority tax distribution provisions
Many advisors favor tax distribution provisions...