Treatment of tax distributions for investor IRR
December 20, 2024
by a searcher from Brown University in New York, NY, USA
Are tax distributions to equity investors considered when calculating investor IRR? I've seen models, including the one linked to here (https://acquiringminds.co/webinars/how-to-model-a-self-funded-sba-acquisition), that include tax distributions but intuitively I'd think these would be excluded as those are pass through distributions that are not retained by the investor.
from The University of Chicago in Chicago, IL, USA
First, investor's expected IRR is assumed to be pre-tax IRR (CAPM, T-bill, stock return, etc. are all pre-tax)
In PTE (pass-through entity), the company makes yearly distributions to cover investor taxes. Investor is deemed to pay the amount received to IRS and hence is left with no $. Investor's actual % tax is ignored. So, such annual distribution does not affect IRR.
However, at the back end i.e. Exit, the tax basis of the investor is the retained earnings plus original equity (say $X). This $X portion of the sale proceeds is tax=free to the investor. This $X should be grossed up to pre-tax for IRR calculation. For simplicity, assume the exit value is equal to $X. The investors pay no tax on $X. Hence, for IRR calculation purposes the $X should be grossed up to pre-tax dollar.
Happy to talk if needed.
from University of Oxford in Texas, USA
I suspect what you're looking at is a function of corp structure (passthrough entity e.g. S-Corp). Whenever the Co generates a profit, it incurs a tax liability. (a) investor % ownership of equity x (b) total tax liability is (c) investor tax liability. Will be reported on a K-1 -- their partnership interest generated income. The Co sends (c) as a distribution to its investors.
That distribution at the portfolio level still counts towards the total $ amount returned (which, of course, drives IRR). It is on the investor to create tax efficient strategies / structures to minimize ultimate taxes paid.