Many business entities are structured as "pass-through" entities for tax reasons. These include not only corporations which make a Subchapter S election ("S corporations"), but also limited liability companies ("LLCs"), as well as general and limited partnerships.

In these entities, no tax is paid at the entity level (although the State of California does impose certain taxes and fees on each of these entities other than a general partnership). Rather, the entity's income "passes through" to its owners for tax purposes. Each owner receives on an annual basis a Schedule K-1 which lists that owner's distributable share of the entity's income. For example, assume there is a LLC with two members; Member A (50% interest) and Member B (50% interest). Each member will receive a K-1 each year which will report 50% of the net income of the LLC to each member. For example, if in a given year the LLC had net income of $1,000,000, each of Member A and Member B would receive a K-1 reporting $500,000 of income. Each of Member A and Member B would have to pay federal income and state franchise tax based on that allocation of income.

Tax Allocations and Cash Distributions

One important concept to keep in mind about pass-through entities is that the K-1 recipient must pay the recipient's distributable share of the entity's net income, regardless of whether in fact the entity makes any distribution of cash to the K-1 recipient to fund that tax obligation.

Going back to our example above, each of Member A and Member B owes taxes on the $500,000 of the LLC's net income allocated to that member, even if the members decide to keep all of that money in the business for whatever reason, such as future expansion, etc.

Of course, most pass-through entities distribute sufficient cash to their K-1 recipients to fund the tax obligations of those recipients based on the amount of income allocated on the K-1. Going back to our example above, the LLC might distribute $200,000 to each of Member A and Member B, allowing each of those members to fund tax obligations.

Many agreements governing pass-through entities state that any distributions will be determined in the discretion of one or more persons. For example, a Shareholders' Agreement for an S corporation would state that any dividends shall be subject to approval by the board of directors. The board might or might not be made up of each of the owners. In an Operating Agreement, it might be provided that any cash
distributions will be made on agreement of the members, or by those members holding a majority of the outstanding membership interests (if the LLC is member-managed) or by the LLC's manager(s) (if the LLC is manager-managed).

Consideration needs to be given to situations where one owner needs a distribution to pay his taxes, and the other owner does not. For example, assume that an investor owns 80% of an LLC, and the CEO owns 20%. The investor has other sources of cash available to fund tax liability on income allocated by the LLC, and would prefer that cash be reinvested in the business. While the CEO also sees the need to reinvest some of the profits in the business, the CEO needs the LLC to make a cash distribution to fund the tax liability the CEO incurs annually based on the income allocated to the members. If the Operating Agreement provides that all cash distributions are subject to approval of a majority-in-interest of the members (determined on a percentage interest basis), the CEO might not be able to fund the tax obligations imposed as a result of the LLC's income allocations.

Often, well-drafted agreements will provide that while generally distributions will be discretionary, at a minimum the entity will distribute to the owners that amount of cash necessary for the owners to fund tax obligations as a result of having been allocated income by the entity, calculated at the highest marginal rates. This allows a non-controlling owner to know that tax obligations imposed by having receiving allocations of income from the entity will be funded.

Subchapter S Requirements

While partnerships and LLCs have the flexibility to make "special allocations" and distributions to partners and members (that is, allocations and distributions that are not in accordance with the respective percentage interests of the partners and members), an S corporation risks termination of its S corporation election if it makes allocations or distributions to shareholders which are not in strict accordance with the shareholders' respective percentage interests. Thus, for example, equal shareholders in an S corporation cannot agree to share the proceeds of a sale other than in those equal percentages.

Contractual Limitations

Another issue to consider is contractual restrictions or prohibitions that the entity might be required to agree to which would restrict or prohibit the entity from making distributions to its owners. For example, a loan agreement will typically provide that the borrower cannot make any distribution to its owners without the consent of the lender. Rather than trying to obtain such consent on an ongoing basis for each distribution, the borrower should try to negotiate a provision in the loan agreement that allows it to make certain distributions to its owners without lender consent (for example, to fund tax obligations).

Issues on Sale of a Business

When an owner sells his interest in a pass-through entity, after the sale is complete the owner will receive a K-1 for the short-year ending on the date of sale. For example, an owner who sells on August 31 of a year will receive a K-1 for the selling owner's share of the entity's income for the year up through August 31, and will need to pay tax on that allocated income. Consideration therefore needs to be given during the sale negotiation as to how the owner will fund this tax liability.