Tax Distribution

What is a tax distribution?

A tax distribution is a payment from a pass-through entity to its owners specifically to cover their tax liability on the entity's income. Since S corporations, partnerships, and LLCs do not pay entity-level income tax, owners owe tax on their share of profits. Tax distributions provide cash to pay this tax bill even when the entity retains earnings for operations or growth.

Calculating tax distributions

Most tax distribution provisions multiply each owner's share of taxable income by an assumed tax rate, often the highest marginal rate. Some agreements use each owner's actual rate, but that requires sharing personal tax information. The distribution covers the tax, and any remaining profits may be distributed separately or retained. Timing matters because quarterly estimated taxes are due before year end.

Operating agreement provisions

Your operating or shareholder agreement should require minimum tax distributions. Without this provision, you could owe tax on phantom income with no cash to pay it. The agreement should specify how tax distributions are calculated, when they are paid, and whether they are advances against future profit distributions. Review these provisions before investing in any pass-through entity.