By Kenneth H. Bridges, CPA, PFS February 2013
One of our venture capital/private equity clients recently asked us whether, in light of the increase in tax rates, they should increase the tax distribution rate for their funds and, if so, what the rate should be. That seems like a simple enough question, but, unfortunately, it is not.
The actual marginal rate impact on taxpayers from K-1 flow-through income can be all over the board (ranging from 0% to well over 50% depending on the type of income (ordinary, long-term capital gain, qualified dividend, etc.), the carryovers they may have (e.g. capital loss carryovers, passive loss carryovers, and credit carryovers), their state of residence, the state sourcing of the K-1 income, current year tax credits generated by the pass-through entity, whether or not subject to self-employment tax, whether they are in exemption and deductions phase-out range, and whether or not in the alternative minimum tax (AMT).
Effective for 2013, the highest regular Federal tax rate bracket is now 39.6% for ordinary income and 20% for qualified dividends and long-term capital gain. If the income is subject to the new Medicare tax on net investment income (e.g. interest, dividends, rents, royalties, most capital gains and “passive” income) then you can add another 3.8% to that. The impact of the phase-out of itemized deductions (3 cents for each dollar of additional income) could effectively add another 1.2% to that, so, for a high income person, an additional dollar of passive business income could be subject to an all-in Federal rate of about 44.6%.
Then you have the states, where the marginal rate can range from 0% (e.g. Florida) up to 13.3% (e.g. California). However, assuming a person was in the highest Federal rate bracket (which would mean they are not in AMT) and got good tax advice and properly timed the payment of their state income tax (to get deduction in the year in highest Federal rate bracket and not in AMT), then the effective state rate (after Federal benefit) is only about 60% of whatever the stated rate is.
The tax distribution provisions in the operating agreements/shareholder agreements we see vary. Some say to use the highest Federal and state rates currently in effect. Some use a flat percentage like 40%. Some say the entity’s accountant will make the determination. Some agreements say you take into account prior losses which have been passed through to the members (to avoid a situation whereby an LLC or S-corp loses money for years and then the first time it has a profit has a required tax distribution even though cumulatively it has still reported a big loss).
Unfortunately, there is no simple answer to this question. If you try to go with a flat percentage that will cover all conceivable situations, then you will most likely end up with a required distribution percentage that greatly exceeds the marginal tax impact on any of the owners. Some judgment and discretion are generally in order here.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.