11 Things to Consider When Negotiating a Tax Distribution Provision
The owners of pass-through entities: partnerships (including limited liability companies—LLCs—taxed as partnerships) and S corporations, must pay tax on their share of the entities’ profits, irrespective of whether the pass-through entity distributes any of those profits to the owners. This disconnect creates the possibility of “phantom income”—taxable income without a matching distribution of cash—for the owners. Since pass-through entities have no statutory obligation to make distributions to cover their owners’ tax liabilities, the owners must address this issue when negotiating their partnership, LLC, and shareholders’ agreements.
Those negotiations often result in a tax distribution provision that requires the pass-through entity to make cash distributions intended to enable the owners to pay their tax liability; however, unless the tax distribution provision is drafted carefully, it may undermine the economics of the deal the parties agreed to. Here is a list of things to things to consider when negotiating a tax distribution provision:
Are the owners able to pay their tax liability without receiving a tax distribution?
If any of the owners will be dependent on cash distributions to pay their taxes, then the absence of a tax distribution provision will be a hardship or, even more ominously, a weapon in the hands of the controlling owners, if they can make do without the tax distribution.
Are any of the owners employees who have been awarded equity, or sweat equity owners of “carried interests”? If so, the absence of a tax distribution could cause the good feelings from receiving the equity to turn bitter at tax time.
Are any of the owners trusts? If so, they may not have any other source of funds from which to pay the tax or make distributions to their beneficiaries who must, in turn, pay tax on the income of the trust (including the income allocated to the trust from the pass-through entity). The result may be that the trustee is caught in the middle between disgruntled beneficiaries and the controllers of the pass-through entity.
Are the owners exempt from tax, or do they have tax losses from other investments that can offset the income from the pass-through entity, so that they have no net tax liability? If so, then tax distributions could strip cash from the business unnecessarily.
Will the pass-through entity be able to make tax distributions?
Does the business need to retain its profits to fund its growth, or meet its contractual commitments? If so, then the owners must be prepared to fund their tax liabilities from other sources.
Will the pass-through entity be leveraged? If so, then the terms of the loans must be negotiated to permit tax distributions before the tax distribution provision can be included in the entity agreement.
The tax distribution provision is a distribution provision.
Although the reason for the provision may be to avoid phantom income, it almost always overwrites the distribution waterfall, at least to some degree; and in some cases, it significantly alters the economic arrangement that the parties thought they had agreed to. For example, suppose a partnership has two partners: a sweat-equity partner and a money partner. The sweat-equity partner will operate the business, and the money partner will contribute $500 in capital. The economic arrangement is that the $500 in capital will be returned to the money partner first, before any other distributions are made; then the partners will share cash distributions equally. Nevertheless, applicable tax accounting rules will cause the sweat-equity partner to pay tax on half of the income; but without a tax distribution provision, he will not receive any cash to pay the tax until the money partner receives all of her capital.
A typical tax distribution provision would override, at least in part, the money partner’s priority return of capital, and provide the sweat-equity partner with a cash distribution, up to the amount needed to pay his taxes. This override can be significant if a large portion of the profits are reinvested in the business or used to repay debt.
Suppose the business earns $100 of profits in year one, $60 of which is retained by the company and reinvested in a capital asset (or used to repay debt); and each partner’s tax rate is 40%. Each partner’s tax liability is $20 ($50 x 40%); however, without the tax distribution provision, the $40 of distributable cash would be distributed entirely to the money partner.
A tax distribution provision would override that distribution scheme resulting in a distribution of $20 to each partner, supersede the money partner’s priority return of capital in the first year of the business, and allow the sweat-equity partner to build his equity without a cash outlay. Is that really the deal? Should it be?
If the company continues to be profitable, then at some point the money partner’s priority return of capital will result in the return of her capital; however, the tax distribution provision delays this, and thus alters both the timing and the priority of the agreed upon “economics” of the deal.
Are the tax distributions advances against the overall distributions, or in addition to them?
If tax distributions will be advances against subsequent distributions, then the next issue to resolve is what future distributions should be offset. Should the tax distributions offset the next distributions that the entity makes or should they come out of some other tier in the distribution waterfall, perhaps even affecting only the liquidating distributions? This can be an important question because delaying the offset will change the timing of future distributions.
While it may seem self-evident that a distribution made under a tax distribution provision should be an advance against and offset future distributions, some tax distribution provisions treat the tax distributions as an addition to the other distributions and not advances against them.
For example, suppose a private equity firm invests $100 in an LLC (taxed as a partnership) in exchange for a non-participating, preferred interest. The distribution waterfall in the LLC agreement provides that current distributions of free cash flow are to be made first to the private equity firm in the amount of an annual 8% preferred return on its unreturned capital, second to the private equity firm in an amount equal to its unreturned capital, and thereafter to all of the other owners in proportion to their percentage interests in profits. Assume also that the LLC agreement includes a tax distribution provision that covers only the annual 8% preferred return due to the private equity firm. The amount of the tax distribution is 40% of the income allocated to the preferred return.
If the tax distribution provision does not specify that the tax distributions will reduce future distributions to the private equity firm, then the private equity firm is likely entitled to the tax distributions in addition to the annual 8% preferred return. Assume that in the first year of operation, the LLC generates $50 in net taxable income and that it also generated $50 in free cash flow that it will distribute. The private equity firm would receive $8 for its preferred return and another $5.33 as a tax distribution, so that it will be allocated $13.33 of income, pay $5.33 of tax on the allocated income, and be left with $8, net. The private equity firm has essentially structured its preferred return as an after-tax return with the other owners paying the private equity firm’s tax liability.
The takeaway here is that when negotiating the tax distributions, it is essential to clarify whether the tax distributions are advances against other distributions or are in addition to other distributions.
Is Section 704(c) taken into account?
Internal Revenue Code Section 704(c) applies to pass-through entities that are taxed as partnerships. If a partner contributes an asset to a partnership and the fair market value of that asset differs from its income tax basis (“704(c) Property”), then Section 704(c) requires that differential to be taken into account in allocating tax items with respect to the 704(c) Property. Section 704(c) can have a substantial impact on the economic relationship of the parties and, in a forthcoming edition of this newsletter, we will explain its ramifications. For the purposes of this article, however, it is sufficient to know that a partner who contributed 704(c) Property with a value greater than its income tax basis will, ultimately, be taxed on more income than her share of partnership profits, because the profits of the partnership are measured by using the value of the contributed property, rather than its income tax basis.
Suppose that A and B form a 50/50 partnership, with A contributing land with an income tax basis of $25 and a value of $100, i.e., 704(c) Property, and B contributing $100 in cash. The partnership holds the land until its value increases to $150, when it is sold, and the proceeds of sale—$150, are then distributed to the partners equally—$75 each. The partnership has realized a profit of $50 ($150 sales price of the land – $100 value at time of contribution); however, it has realized income taxable gain of $125 ($150 sales price – $25 income tax basis).
Section 704(c) requires that A be allocated $100 of that gain—$75 of which is the “built-in gain” ($100 value – $25 income tax basis) that was present when A contributed the 704(c) Property to the partnership, and $25 of which is A’s 50% of the gain that arose from the appreciation while the land was held by the partnership.
Now suppose that the partnership agreement includes a tax distribution provision, which requires a tax distribution of 23.8% (the capital gain tax at 20% + the net investment income tax at 3.8%) of the gain allocated to each partner. Is A’s tax distribution calculated using the $100 of gain on which he is taxed, or only the $25 of gain that arose after he contributed the property to the partnership?
One can see from this simple example that it is essential to specify whether A’s tax distribution includes the tax on the built-in gain. The issues caused by 704(c) Property become far more complex when that property is depreciable or amortizable by the partnership, and can arise in many circumstances. For instance, the admission of a new partner to an existing partnership can cause the property owned by the partnership to become 704(c) Property, whether the new partner contributes only cash, or worse, if the new partner contributes property, when both the existing partnership property and the contributed property have to be accounted for as 704(c) Property.
Are the tax distributions based on yearly or cumulative income?
Whether the tax distributions are calculated from annual or cumulative income allocations can have a significant effect on the total amount of tax distributions that are made during the life cycle of the business.
The annual method calculates the tax distribution by multiplying the owner’s income allocation for the year, if it is positive, by the tax rate. The cumulative method, however, takes into account allocations of income and loss from the beginning of the partnership. Sound arguments can be made for using either method; but an informed choice can only be made by considering the specific circumstances of each partnership.
How is the Tax Rate calculated?
One of the fundamental elements of a tax distribution provision is the tax rate. Common issues that arise in determining the tax rate are: (1) whether the tax rate will be uniform or determined separately for each owner; (2) whether to include state and local taxes; (3) if state taxes are included should there be an adjustment for the state tax deduction (and what if the deduction affects the alternative minimum tax); (4) should self-employment taxes be included; (5) should the net investment income tax be included; (6) should the application of the alternative minimum tax be considered; and (7) should the tax rate adjust for the character of the income being allocated?
The administrative ease of using a stipulated rate for all partners will often prevail over the precision of calculating each partner’s individual rate. To illustrate, simply consider the provisions in the 2017 tax legislation that have created the 20% deduction for certain types of income earned through pass-through entities and reduced the benefit of deducting state taxes, both of which are subject to sunset provisions.
What if the income allocation changes because of an audit or litigation?
This is an area that is often not addressed because of the complexity it creates. Also, the IRS has new streamlined audit rules for tax years starting after December 31, 2017, that will result in most tax assessments and subsequent collections occurring at the partnership level. These adjustments and collections will not flow through to the partners unless the partnership is eligible to and opts-out of the new audit rule regime.
If the partnership does opt-out and also wants to indemnify its partners for changes on audit or in litigation, then part of the discussion should involve who will control the audit or litigation and who must consent to a settlement.
Final Year and Clawbacks.
If the tax distributions are advances and not additive distributions, the parties should resolve whether tax distributions should be made after a liquidity/exit event or in the last year of the business.
Owners should discuss whether tax distributions that ultimately exceed all of the distributions due to an owner should be clawed back, and if so, whether a similar principle applies when a partner is bought out of the partnership mid-stream.
How often should tax advances be made?
The frequency of tax advances must balance the cash flow needs of the owners against the administrative burden that frequent tax advances impose on the entity. If the owners can finance their own quarterly tax payments, then tax distributions can be made only once a year. Quarterly tax distributions are more likely to result in a tax distribution that exceeds the actual tax distribution that should have been made. Quarterly tax distributions can be coupled with a clawback requiring the return of the excess distribution; however, these are often hard to enforce.
S corporation shareholders must also consider the desirability of having a shareholders’ agreement that provides for tax distributions; particularly those having trusts as shareholders. While many of the issues discussed above will not apply to shareholders in S corporations, because all distributions to S corporation shareholders must be made ratably, in accordance with their share ownership, consideration must still be given to how tax distributions will be handled when shareholders sell their shares, or have them redeemed by the corporation.
 See Interactivecorp. v. Vivendi Universal, S.A., C.A. No. 20260 (Delaware Chancery Court (July 6, 2004)) , 2004 WL 1573963.