Let's Debate - Investor Tax Distributions

June 16, 2025

by a searcher from Massachusetts Institute of Technology - MIT Sloan School of Management in Seattle, WA, USA

Curious to get the community's thoughts on how to model and consider self-funded investor tax distributions. Talking to fellow investors and searchers, it seems like distributing cash each year (including the first) to investors to cover their expected tax bill at ~35% of net profits is typical. What is debatable are the following: * Does the tax distribution deduct from the total investor principal/return of capital (e.g. $10K per year for tax distributions over 5 years would deduct $50K from an investors $500K investment, leaving them with $450K to be returned in the exit waterfall) * Does the tax distribution go into the IRR and MOIC calculation (regardless of the answer above) as it is a cash outlay? * Is it considered in the SBA 7a DSCR calculation since it is a cash outlay but it can be deferred in many cases * If it can't be paid in one year due to a slowness in the business, what happens. Does it accrue? Interested in investors and searchers answers to these questions and your mental model on the subject. The answers can have a material impact on how the searcher runs their business and models IRRs.

Reply by a searcher
from Columbia University in Fairfax, VA, USA

A lot of what you’ve asked can vary on the type of investor you’re raising from — but generally speaking: 1) No, because Tax Distributions are typically pass-through if you have an LLC or S-Corp, it’s not an economic gain for the investor. 2) It’s debatable whether or not it gets factored into your return metrics (IRR, MOIC). I’ve seen it both ways. 3) It does factor into DSCR. There are many types of investor distributions that can be discretionary — the one that can’t are Tax Distributions. If your business has Taxable Income in a given year, those Tax Distributions need to be paid out because the IRS will collect (again, if you have an S-Corp or LLC). Income Taxes get calculated in the Unlevered Free Cash Flow number, which is what lenders use to calculate DSCR. 4) No, it doesn’t accrue. It’s calculated and paid out within each fiscal year (but can be paid quarterly or annually depending on the dynamics of your business and what’s in your Operating Agreement).

Reply by a searcher
from IMD in Orlando, FL, USA

? 1. Do tax distributions reduce return of capital? NO  Most investors and searchers do not deduct tax distributions from the return of capital. The reasoning: * Tax distributions are viewed as “pass-through relief” for taxes due on phantom income (K-1 profits without matching cash). * These are not a return on or of investment, but a required cash accommodation. Some investor agreements might define tax distributions as part of the waterfall, or in rare cases reduce capital if the distributions are excessive relative to real tax liability. It should be explicit in the legal docs. ? 2. Do tax distributions count in IRR and MOIC calculations? * IRR: Tax distributions are real cash to the investor. Even if they’re being used to pay the IRS, it’s still a cash flow, and it boosts the IRR because it's early. * MOIC: Typically no, because MOIC usually reflects return above invested capital, and tax distributions are not return on investment. That said, if you use a cash-only MOIC (as some do), you might include it. Treat tax distributions like dividend cash flows. IRR cares when cash comes; MOIC cares how much profit you got beyond capital. ? 3. Do tax distributions affect SBA 7a DSCR? NO (but gray area) * SBA 7a DSCR is typically calculated using EBITDA / Debt Service, where tax distributions are not counted as a required debt service component. * Banks and underwriters know this. Some will stress test DSCR assuming ~35% of income distributed. Include tax distributions in your internal DSCR stress scenarios, even if the lender doesn't formally require it. ? 4. If tax distributions can't be paid, do they accrue? YES, they accrue * If the business doesn’t have enough cash to distribute in a high-tax year, most investor agreements state that the unpaid tax amount accrues and must be paid when liquidity allows (e.g., next year or at exit). * Some deals even specify that investors get priority repayment of accrued tax distributions before any profit-sharing. Mental model: This is part of the investor’s tax protection—it’s not waived just because the business was tight on cash. These are all negotiable points in legal docs—especially in self-funded deals. Clarify in advance whether: * Tax distributions reduce capital or not. * There is a fixed or flexible tax distribution policy. * Accrual mechanisms are in place.

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