What are tax distributions?

Many small businesses with investors have provisions for tax distributions in their operating agreements. These tax distributions are designed to ensure that the entrepreneurs and investors are not caught with a large tax bill without having actually received distributions. In this post, we’ll cover a few key concepts in explaining why tax distributions are important, including pass-through entities, phantom tax, and calculating tax distributions.

Small businesses are often structured as pass-through entities

A pass-through entity is a business that does not pay its own taxes. Those taxes are passed on and paid by the owners (business owners), shareholders or partners of the business. A few business structures that are pass-through entities include:

• Sole proprietorships

• Partnerships

• S corporations (S corp)

• Limited Liability Company (LLC)

On the Mainshares platform, the majority of businesses are structured as a Delaware LLC at the parent level, meaning that the entrepreneurs and investors will be responsible for any taxes owed.

LLC’s are a common choice for a business entity because they protect owners (sometimes referred to as members) from personal liability. That way, if an LLC files bankruptcy, the creditors (bankers, credit-based investors, etc) can’t go after the owner’s personal assets (personal property, savings accounts, etc.), unless that owner has signed a personal guarantee (e.g., an SBA loan).

In addition to providing a liability shield, LLCs also avoid double taxation. This occurs when taxes are paid once when a business recognizes a profit and a second time when that profit is distributed to an individual.

Taxes are calculated for each owner in a pass-through entity

In an LLC, business profits and losses are passed through to the owners and taxed at the owner's individual tax rate. 

To calculate how much an owner will owe in taxes, the owner’s share of the profits is multiplied by her individual tax rate.

The tax burden can vary based on what % of the company a partner owns as well as what tax bracket he or she is in. Thus, it’s possible for two people with the same ownership stake to receive two different bills from the IRS.

LLCs can create phantom income for its members 

The pass-through nature of an LLC can be a double-edged sword, especially when the business decides to retain or reinvest its profits into the business. When that happens, phantom income is created - the owners receive a tax bill based on their share of the profits, despite not receiving any distribution of profits to their bank account.

Phantom income is sometimes referred to as “Phantom Revenue”. It is important to note that phantom income is not common; however, when it does occur, it complicates tax planning for owners, partners and shareholders. Therefore, it is important to have a contingency plan in place so that owners do not feel penalized when the business has a strong year and chooses to reinvest for the future.

This leads us to the concept of a tax distribution, which is often a provision in an operating agreement to specifically help shareholders avoid having no means to pay taxes on phantom income.

What are tax distributions?

Tax distributions are distributions that are paid out to members of an LLC so they can settle their tax obligations/liabilities that were brought on by the business (i.e., the business is making a profit). Tax distributions allow owners to plan for future taxes. In addition, tax distributions act as a reserve for owners when their businesses incur phantom income. Thus, owners do not have to worry about digging into their own pockets to pay the Internal Revenue Service (IRS) or some other taxing agency.

A common question asked is, where do I find these tax distribution requirements? The main document to review as a member of an LLC is the company’s operating agreement. Within the operating agreement, there should be stipulations for when tax distributions will be distributed, how they will be distributed and what is the purpose of these tax distributions.

Here is some sample language for how an LLC’s operating agreement allows for tax distributions:

The Manager shall cause the Company, consistent with any restrictions which may be imposed by any creditor of the Company or applicable law, to advance amounts to the Members intended to cover estimated tax liabilities of the Members attributable to allocations to the Members for any Accounting Period prior to dissolution of the Company, determined for each Member by multiplying the net taxable income allocated to such Member for the Accounting Period (reduced, but not below zero, by the amount, if any, by which aggregate losses exceed taxable income allocated to such Member for all preceding Accounting Periods), by the highest federal income tax rate applicable to an individual in such Accounting Period, taking into account the character of income (e.g., ordinary or capital) recognized by the Company during such Accounting Period (“Tax Distributions”)

Another source is in a business’s loan documents, within those loan documents entrepreneurs should be able to see whether the loan covenants have seeked to restrict or override any language in the operating agreement.

When reading these agreements, note whether the tax distribution is calculated based on cumulative returns or on a year-to-year basis. On a cumulative basis, there could be losses that could be rolled over from prior years that lower tax distributions. It is important to understand this because a tax payment higher than what is expected has a direct effect on an owner’s pocket book. 

How do you calculate tax distributions?

Below is an example of a simple tax distribution calculation (assume each owner has a 20 percent stake in the company):

As detailed in the above example, each owner is in a different tax bracket and their individual tax rate is used to determine the size of their tax distribution. Note that it is imperative that owners read the operating agreement and understand how these tax distributions are calculated because some agreements may apply a single tax rate for all owners or some other complex structure.

When are tax distributions made?

Tax distributions are typically paid out when it is most beneficial for partners, owners or shareholders to make their estimated tax payments. Typically, these distributions occur on a quarterly or yearly basis. However, the number of distributions made in a given year is dependent on the needs of current owners, partners, or shareholders.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.