What Are Funds Available for Distribution?

Funds available for distribution represents the cash an entity has generated that can be paid out to its owners or beneficiaries. Investors and beneficiaries use this metric to gauge the cash-generating ability of an entity, especially for pass-through entities like trusts. This figure shows the actual cash an entity can return to stakeholders after accounting for its operational and investment needs.

Calculating Funds Available for Distribution

The calculation for funds available for distribution (FAD) begins with an entity’s net income. A series of adjustments are then made to reconcile accounting profit with actual cash flow. While no single standardized formula exists, the principles are widely applied, particularly in real estate investment.

The first step is to add back non-cash expenses, such as depreciation and amortization, that were deducted from net income. These accounting entries spread an asset’s cost over its useful life but do not represent a cash outflow in the current period. For instance, depreciation on a building reduces net income without using any current cash. Adding these expenses back reverses the non-cash reduction.

Other non-cash items, such as deferred tax expenses or losses on the sale of assets, are also added back. For instance, a loss on a property sale reduces net income, but the actual cash impact is related to the sale proceeds. These adjustments help clarify the cash generated from core operations.

Next, cash expenditures not immediately expensed on the income statement are subtracted. A primary example is capital expenditures (capex), which is money spent on acquiring or upgrading physical assets like property or equipment. While a large cash outflow, the cost of a new asset is recognized over time through depreciation. Subtracting recurring capex ensures the FAD figure reflects the cash needed to maintain the business’s assets.

Another subtraction is for principal payments on debt. When a business makes a loan payment, only the interest portion is recorded as an expense on the income statement. The part of the payment that reduces the loan principal is a cash outflow that does not affect net income and must be subtracted.

Application in Trusts and Estates

For trusts and estates, distributable funds are governed by legal and tax frameworks. The trust agreement is the primary document dictating what can be distributed, specifying how to distinguish between the trust’s “income” and its “principal.” State laws, often based on the Uniform Principal and Income Act, provide default rules for this allocation when the trust document is silent.

For tax purposes, Distributable Net Income (DNI) is a calculation that sets the maximum amount of a trust’s income that can be taxed to the beneficiaries. DNI is calculated on Form 1041, the U.S. Income Tax Return for Estates and Trusts, by adjusting the trust’s taxable income. Adjustments include adding back the personal exemption and tax-exempt interest, while subtracting capital gains allocated to principal.

DNI limits the distribution deduction the trust can claim and determines the amount and character of the income beneficiaries must report. If a trust distributes more than its DNI, the excess is treated as a tax-free distribution of principal. This mechanism prevents the double taxation of trust income.

The 65-day rule allows a trustee to make a distribution within the first 65 days of a new year and elect to treat it as if made in the preceding year. This flexibility helps trustees manage the trust’s tax liability, as trust income tax brackets are highly compressed. The election is made on a timely filed Form 1041 and is irrevocable.

Application in Business Entities

For partnerships and LLCs, the rules for distributions are established by the entity’s governing documents, such as a partnership or operating agreement. These documents define how “distributable cash” is calculated and when payments are made to owners. The agreements are customizable and allow terms for cash distributions to differ from the allocation of taxable income.

These entities are pass-through structures, so the business itself does not pay federal income tax. Instead, profits and losses are passed directly to the owners, who report their share of the income on their personal tax returns. This structure avoids the double taxation found in C corporations.

Real Estate Investment Trusts (REITs) are a specialized business structure with a distinct distribution requirement. To maintain their tax-advantaged status, REITs must distribute at least 90% of their taxable income to shareholders annually as dividends.

Failure to meet this 90% threshold can result in penalties, including a 4% excise tax on the undistributed income or the loss of REIT status. Consequently, most REITs aim to distribute 100% of their taxable income. REIT investors closely monitor FAD as an indicator of the company’s ability to sustain its dividend payments.

Tax Implications of Distributions

For pass-through entities, the character of the income—such as ordinary business income, interest, or capital gains—is maintained as it flows to the owners or beneficiaries. For example, if an entity earns tax-exempt interest, that tax-exempt quality also flows through to the recipient.

Recipients of distributions from these entities receive a Schedule K-1. This tax form details the recipient’s share of all income, deduction, credit, and loss items for the tax year. For example, partners receive a Schedule K-1 (Form 1065) and trust beneficiaries receive a Schedule K-1 (Form 1041), which they use to complete their personal tax returns.

A cash distribution is not always immediately taxable, as its taxability depends on the recipient’s “basis,” or their investment in the entity. A distribution that exceeds the recipient’s allocated income for the year may be treated as a non-taxable return of capital, which reduces their basis. After the basis is reduced to zero, further distributions are taxed as a capital gain.

It is important to distinguish between the allocation of income and the distribution of cash, as an owner is taxed on their share of an entity’s income regardless of whether the cash is actually distributed. For instance, if a partnership retains profits for reinvestment, the partners must still pay tax on their allocated share of that income. This can create a situation where a partner owes tax on “phantom income” they have not yet received.