While partners usually groan upon receiving capital calls, they are delighted to receive distribution checks. However, provisions regarding distributions can be convoluted and require more than perfunctory consideration. Any distribution provision more complicated than “pro rata in the ratio of capital contributions” should be carefully coordinated with the provisions governing allocation of income and loss. It is often the case that allocations of profits mirror the distribution provisions (except that allocations of income should not generally be made with respect to capital contributions), but this leaves open how losses should be distributed. Further, distribution provisions that have substantial and/or multiple contingent distribution provisions are often best served by “targeted” allocations of income and loss; these types of provisions have not been expressly approved by the Internal Revenue Services, but they are common in agreements that do not have other specific tax requirements (e.g., conformance to the “fractions rule” under Section 514(c)(9) of the Internal Revenue Code (the “Code”) to avoid certain types of unrelated business taxable income). Care should be given, however, not to mix distribution and allocation terms; “profits” or “revenues” should not be distributed, but only “receipts” or other assets.
There are common alternatives in providing for “preferred returns” (or “meters” or “hurdles”) in distribution provisions. In some contexts, it is customary to think in terms of debt so that a preferred return (for the use of funds) is the first distribution tranche and only when all accrued preferred returns are distributed would capital be returned; where distributions are bifurcated between operating cash flow and proceeds from capital events, it is common for capital to be returned from only the latter source. Where the business deal is based on an internal rate of return (IRR), however, the calculation of the IRR requires knowing the period that the capital is outstanding (i.e., both the date capital is contributed and the date capital is returned), so the additional amount constituting the return on capital follows the return of capital. In transactions where there are minimal distributions prior to a final realization event, these alternatives result in substantially, or actually, identical amounts, but where there is substantial interim cash flow, or multiple events of capital contributions and returns of capital, these can result in materially different amounts.
Because fees for services result in reduction of amounts available for distribution to the partners, payments of these amounts to partners or partner affiliates should be specifically addressed in a partnership agreement, whether by being tied to approved budgets or expressly set forth. Where services are substantially, a separate agreement should be entered into that provides for the right to terminate the services and payments, and other provisions customary in an arm’s-length agreement. For tax purposes, it is essential to differentiate between distributions to partners and payments of fees or other fixed amounts to partners. While it is usually clear, best practice is to address fees or other payments to partners (or their affiliates) in provisions clearly separate from the distribution provisions, often physically in a completely different section of the agreement. Further, such payments should be labeled “guaranteed payments” under Section 707(c) of the Code, which are taxable to the recipient and deductible by the payor, even when made to someone who is a partner in the partnership. One drafting concern is that payments to partners, or even to third parties, of fees are subordinated to the return of capital or other payments labeled as “distributions”; this creates the risk that such payments are actually distributions, in that the recipient is a partner sharing in the entrepreneurial risk of the enterprise.
While most distributions are not themselves tax events (either because they constitute a return of capital already reflected in a capital account or constitute a distribution of profits already allocated to a capital account), there are circumstances where a distribution can be a taxable event. If a partner receives a distribution greater than the tax basis of his interest, the excess is taxable, albeit as capital gains.
Many partnership agreements provide for “tax distributions” to minimize or avoid phantom income. Because allocations of income and gain do not usually have a direct relationship to distributions, partners can receive extensive allocations of income for a year in which they do not receive distributions; for example, cash receipts from a sale may be applied to repay debt or may be reserved for anticipated expenses. This “phantom” income is a burden, unless a partnership is obligated to use some of its cash to make distributions to partners in some amount to pay the tax burden. Tax distributions are sometimes deemed loans to be repaid (sometimes with interest) from future distributions, but are often just considered advances of distributions. Tax distribution provisions often provide for annual distributions, but individuals are subject to four payments of estimated taxes each year; so even annual tax distributions may be insufficient. Tax distributions are based sometimes on only a single year’s calculation of taxable income and sometimes upon aggregate allocations of income and loss, and aggregate distributions, over the life of the partnership to minimize distributions outside the principal and negotiated distribution provisions. A well-written tax distribution provision will include an obligation to return tax distributions if such provision results in greater distributions to a partner than would have been made if the tax distribution provisions did not exist.
Most partnership agreements do not permit a partner to unilaterally withdraw from the partnership, either in part or completely; this includes the right to withdraw from a partner’s capital account. A partner who can withdraw has a claim against partnership assets, which are usually illiquid, so permitting a partner to withdraw before the end of the partnership could require contributions by partners to fund the withdrawal (which is typically a deemed sale, creating its own tax issues), the incurrence of unexpected debt of the partnership or require a premature sale of partnership assets at unfavorable prices. Since none of these are generally desirable consequences, withdrawals should be expressly prohibited. There may be other exit rights in a partnership agreement, such as a buy/sell provision or a right to require the sale of the partnership assets and dissolution of the partnership, but these types of provisions are usually given more careful scrutiny and consideration than a deceptively simple right to withdraw. Where the business arrangement is to permit exits of partners (e.g., hedge funds or other partnerships holding reasonably liquid investments), the agreement should consider necessary income/loss allocations upon any partial or total withdrawal, keeping in mind that non-pro-rata allocations create their own set of issues, as well as allocation of transaction costs, the expected speed that cash can be obtained and third-party limitations on such use of partnership property.