What Is a Tax Distribution for a Pass-Through Entity?

A tax distribution is a specific type of payment from a pass-through business to its owners. These entities, which include S corporations, partnerships, and most limited liability companies (LLCs), do not pay federal income tax at the company level. Instead, the profits are passed to the owners, who then report this income on their personal tax returns. The purpose of a tax distribution is to provide these owners with the cash needed to cover the personal income tax liability generated by the company’s profits.

These payments are fundamentally different from distributions taken from a retirement account, such as a 401(k) or an Individual Retirement Arrangement (IRA), which are governed by entirely separate tax rules. This discussion is focused exclusively on distributions made by pass-through operating businesses to their equity holders.

The Concept of Pass-Through Taxation

Pass-through taxation is a system where a business entity’s income, losses, deductions, and credits are not taxed at the corporate level but are instead passed directly to the owners. Structures like S corporations, partnerships, and LLCs file an annual information return with the IRS, such as Form 1120-S for S Corporations or Form 1065 for partnerships, but they do not pay the primary income tax. The responsibility for the tax liability shifts to the individual owners, who report their share of the entity’s profits on their personal tax returns, detailed on a Schedule K-1. This avoids the “double taxation” experienced by C corporations, where profits are taxed once at the corporate level and again when distributed to shareholders as dividends.

This structure creates a situation for owners known as “phantom income.” An owner is required to pay income tax on their allocated share of the company’s profits for the year, regardless of whether the company actually distributed any of that profit to them in cash. For example, if a two-person LLC earns $200,000 in profit and the partners have an equal split, each owner must report $100,000 of income. This is true even if the business decides to retain the entire $200,000 to fund future expansion. Without a corresponding cash payment, owners would be forced to use money from personal savings to satisfy the IRS, and tax distributions are the solution to this problem.

Calculating the Tax Distribution Amount

Determining the appropriate amount for a tax distribution involves a calculation that uses the owner’s share of the entity’s taxable income and an assumed tax rate. The owner’s allocable share of income is formally communicated to them on Schedule K-1. This document breaks down the specific amount of income, deductions, and other tax items that the owner is responsible for reporting.

The second component is the tax rate. Rather than using an owner’s specific tax bracket, companies use an assumed, high-end composite rate to ensure the distribution is sufficient. This rate generally combines the highest individual federal, state, and local income tax rates. The calculation may also be adjusted for other federal taxes. For example, the 3.8% Net Investment Income Tax (NIIT) might be factored in for passive investors.

In a partnership, a tax distribution may be increased to cover an active partner’s self-employment tax liability. For an S corporation, active owners are paid a separate salary subject to payroll taxes, so the tax distribution is typically designed to cover only the income taxes on the owner’s allocated profits. The formula is the owner’s allocable taxable income multiplied by this assumed combined tax rate. For instance, if an owner of an S corporation receives a Schedule K-1 showing $150,000 in income and the company uses a composite tax rate of 40%, the required tax distribution would be $60,000.

The Role of Governing Documents

The authority and mechanics for issuing tax distributions are controlled by the internal governing documents of the business, not the IRS. For a partnership or an LLC, the key document is the Partnership Agreement or Operating Agreement. For an S corporation, this may be covered in the Shareholders’ Agreement or corporate bylaws. These documents are the legally binding contracts that outline the rights and obligations of the owners.

When reviewing these agreements, owners should look for specific clauses related to distributions. These provisions will clarify whether tax distributions are mandatory or discretionary. A mandatory provision obligates the company to make these payments, provided the company has sufficient cash flow, while a discretionary clause gives management the authority to make these distributions but does not require them to do so.

These governing documents often specify the exact formula or tax rate to be used. The agreement should also detail the timing of these payments, such as requiring them to be made quarterly to align with personal estimated tax payment deadlines. It may also establish the priority of tax distributions relative to other types of profit distributions.

Accounting and Tax Reporting

From an accounting perspective, a tax distribution is not a business expense and does not reduce the company’s reported net income. Instead, it is recorded as a distribution to the owner, which directly reduces the owner’s equity or capital account within the business. This entry reflects that the company has returned a portion of its capital or accumulated profits to its owner.

For the owner receiving the funds, the tax distribution itself is generally not considered taxable income. The owner is already being taxed on their share of the underlying business profits, which were allocated to them on their Schedule K-1. The tax distribution is simply the company providing the cash to pay the tax that is already owed on that allocated income. Receiving the cash is a non-taxable event because it represents a return of capital or a distribution of profits that have already been accounted for on the owner’s tax return.

The amount of the distribution reduces the owner’s basis in their ownership interest. This can have future tax consequences, particularly when the ownership interest is sold.