Partnerships and Tax Distributions: What you need to know

Introduction

When a company is structured as a partnership (including an LLC taxed as a partnership; referred to hereafter as the partnership), the company is not subject to tax.  Instead, the taxable income of the company is passed through to the owners (referred to hereafter as “partners”) and the partners are responsible for the tax due on this income.  As a result, the partners may require the partnership to distribute cash to pay the tax due on the operating company’s taxable income.  These cash distributions are referred to as tax distributions.  These distributions are intended to provide the partner with cash to pay the passed through taxable income of the partnership.  Tax distributions are generally advances on future cash distributions from the partnership.  Without a tax distribution provision, the partners would have to use their own cash rather than cash provided by the company to pay the tax.  Drafting the LLC/LPA agreement’s provision related to tax distributions becomes extremely important to manage the timing and dollar amount of these cash distributions.  This article addresses a few commonly utilized practices and definitions to include in the negotiation process of a tax distribution provision.

Definitions

Taxable income

When negotiating the tax distribution provision, the first place to start is defining “income.”  A few of the common items to include in the negotiations:

Built-in gain/(loss) - When determining the taxable income of the company, current taxable income should be the only item emphasized.  Any built in gain/(loss) from a partnership revaluation or contribution of a partner should be disregarded (aka 704(c) layers).  Taxable income allocated to a partner for built-in gain/(loss) would not be related to the current taxable income of the company.  Instead it is related to prior period appreciation or depreciation of the company.  It is commonly excluded from calculating taxable income for tax distributions.

Partner Outside Basis Step Up Adjustments (i.e. 743(b) adjustments) – Similar to built-in gain/(loss), a partner step up adjustment as a result of a partner to partner transaction is not related to the company’s current taxable income.  This adjustment is considered a partner level item and would not be included in the company’s current taxable income.  As a result, it is commonly excluded from calculating taxable income for tax distributions.

Suspended tax deductions (e.g. 163(j) interest expense limitation) – As a result of the TCJA starting on January 1, 2022, the deduction for interest expense of the company is limited to approximately 30% of Earnings Before Interest & Taxes (“EBIT”).  This suspended interest expense is passed through to the partners.  However, the suspended interest expense is not deductible in the current year.  It is deductible upon the earlier of: 1) the company passing through to the partner excess taxable income or 2) the sale of the partner’s interest in the partnership.  For purposes of calculating taxable income for tax distributions, suspended interest expense is an available future deduction for the partners of the partnership.  Because suspended interest expense may be a substantial item of the partnership, negotiating inclusion or exclusion of this deduction should be emphasized during the negotiating process when defining taxable income for tax distributions.

Cumulative – Tax distributions are intended solely to be utilized by the partners to supplement their tax liability from taxable income of the partnership.  If the partnership had taxable losses in prior years, these losses should be considered in a year when the partnership has current operating taxable income.  A cumulative taxable income approach when calculating current operating taxable income appropriately matches the sole intention of tax distributions.  For example: a partnership has current taxable losses of ($500) and ($100) in years 1 & 2 and taxable income of $1,000 in year 3.  The cumulative taxable income approach would yield taxable income of $400 for purposes of calculating the tax distributions in year 3. 

Assumed tax rate

When calculating a tax distribution, a common practice is to multiply taxable income by an assumed tax rate.  The result represents the estimated tax liability of the partners for their share of the company’s passed through taxable income.  This amount will also be the size of the tax distribution.  With this in mind, the next step after defining taxable income is to determine the assumed tax rate of the tax distribution.   When determining the appropriate tax rate to apply, a look through approach is recommended.  This approach is partner focused – what is the tax rate the partners will pay on their share of the current taxable income and where the business is located (e.g. which state/local jurisdictions).  Under this approach, it is a common practice to utilize the highest federal income tax rate for an individual (37% for the 2023 tax year) and the highest individual income tax rate of the state where the business is located (e.g. North Carolina 4.75% for the 2023 tax year).  Under this example, the assumed tax rate for tax distributions would be 41.75%. 

If a partner’s share of current taxable income is characterized as passive income, the partner would also be subject to an additional tax of 3.8% known as the Net Investment Income Tax (“NIIT”).  Because this determination is at the partner level, this additional tax is commonly excluded from the assumed tax rate for tax distributions.  During the negotiation process, the partnership should consider inclusion or exclusion of this tax rate.

As individual state tax rates have increased, a common feature to manage cashflow of the partnership is the establishment of a maximum assumed tax rate for tax distribution.  This is commonly referred to in tax distributions provisions as the assumed tax rate ceiling.  For example: a maximum assumed tax rate that is commonly used is 45%.  This assumed tax rate is a combination of 1) the highest federal individual income tax rate of 37%, 2) NIIT 3.8%, and 3) a blended state rate of 4.2%. 

Timing

After defining taxable income and the appropriate assumed tax rate, the final step is to determine when to make tax distributions.  A partner is generally required to make quarterly tax estimated payments on the passed through taxable income.  However, the partnership may not have a reasonable estimate of taxable income until Q3 or Q4 of the calendar or fiscal year.  As a result, it is common for a partnership to make one tax distribution in Q4 of the calendar/fiscal year end.

Takeaways

Tax distributions are significant for partnerships and should be carefully considered and negotiated.   Analyzing the definitions of taxable income and assumed tax rate in combination with determining when to make tax distributions should all be part of a company’s cashflow and treasury management functions.

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The information provided in this communication is of a general nature and should not be considered professional advice.  You should not act upon the information provided without obtaining specific professional advice