Partnerships and Tax Distributions: What you need to know

Note: Originally published in January 2024, updated to reflect recent legislative changes.

When a company is structured as a partnership, including a limited liability company (LLC) taxed as one (hereafter referred to as a partnership), it is not subject to tax. Instead, taxable income passes through to the owners (hereafter referred to as partners), who are responsible for paying the tax. To help them meet those obligations, the partnership may distribute cash, known as tax distributions.

Tax distributions are generally advances on future partnership payouts, allowing partners to cover tax liabilities without using personal funds. When drafting the LLC Agreement or Limited Partnership Agreement (LPA), it is extremely important to define the provisions related to tax distributions, as they manage the timing and dollar amount of these payments. This article addresses key practices and definitions to consider during the negotiation of such provisions.

What counts as taxable income for partnership tax distributions?

When negotiating the tax distribution provisions, the first place to start is defining “income.” Common items to consider during these negotiations include:

Built-In Gain or Loss

When determining the taxable income of the company, only the current year’s income should typically be emphasized. Any built-in gain or loss from a partnership revaluation or contribution of a partner should normally be disregarded (e.g., 704(c) layers). Taxable income allocated to a partner for built-in gain or loss would be unrelated to the current taxable income, as it reflects prior appreciation or depreciation. It is commonly excluded from tax distribution calculations.

Partner Outside Basis Step-Up Adjustments ─ 743(b) Adjustments

Like built-in gain or loss, a partner’s step-up adjustment from a partner-to-partner transaction is unrelated to the company’s current taxable income. As a partner-level item, it is commonly excluded from tax distribution calculations.

Suspended Tax Deductions ─ 163(j) Interest Expense Limitation

Under the One Big Beautiful Bill Act (OBBBA), enacted on July 4, 2025, a company’s interest expense deduction may be limited to approximately 30% of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Any interest expense exceeding that threshold is suspended and passed through to the partners. However, this suspended interest is not deductible in the current year. It becomes deductible upon the company passing through excess taxable income to the partner, or adjusts the partner’s basis in the sale of the partner’s interest in the partnership.

For purposes of calculating taxable income for tax distributions, suspended interest expense represents a future deduction available to partners. Since this amount can be significant, it’s important to address its inclusion or exclusion during negotiations when defining taxable income for distribution purposes.

Cumulative Approach

Tax distributions are intended to help partners cover their tax liability from the partnership’s taxable income. If the partnership incurred losses in prior years, those losses should be considered against the current year’s operating income. A cumulative approach to taxable income allows tax distributions to reflect partners’ overall tax obligations based on net income over time.

Example: A partnership has current taxable losses of ($500) and ($100) in years 1 & 2 and taxable income of $1,000 in year 3. The cumulative taxable income approach would yield taxable income of $400 for purposes of calculating the tax distributions in year 3.

How is the assumed tax rate calculated for tax distributions?

To calculate a tax distribution, partnerships typically multiply taxable income by an assumed tax rate. This rate estimates the partner’s tax liability on their share of passed-through income and determines the size of the distribution. Once taxable income is defined, the next step is selecting an appropriate assumed tax rate.

Look-Through Approach

A commonly used method is the look-through approach, which focuses on the partner’s actual tax exposure. This includes considering the highest applicable federal and state individual tax rates based on where the business operates.

Example: Using the 2025 rates, a partnership in North Carolina might apply a combined rate of 41.25% (37% federal plus 4.25% state). This approach aligns the tax distribution with the partner’s expected tax burden.

NIIT Considerations

If a partner’s share of current taxable income is considered passive, it may trigger an additional tax of 3.8% Net Investment Income Tax (NIIT). Since NIIT is determined at the partner level, it’s often excluded from the assumed tax rate used for distributions. However, partnerships should evaluate whether to include or exclude NIIT during negotiations.

Maximum Assumed Tax Rate

As state tax rates have increased, partnerships often manage cash flow by setting a maximum assumed tax rate (also known as the assumed tax rate ceiling) within their tax distribution provisions.

Example: A commonly used maximum rate is 45%, which combines: 1) the highest federal individual income tax rate of 37%, 2) the 3.8% NIIT, and 3) a blended state rate of 4.2%.

When should partnerships make tax distributions?

After defining taxable income and the assumed tax rate, the final step is to determine the timing of tax distributions. Although partners are generally required to make quarterly estimated payments on passed-through income, partnerships may not have a reasonable income estimate until later in the year. As a result, it’s common for partnerships to issue a single tax distribution in the fourth quarter of the calendar or fiscal year.

We Can Help

Tax distributions are significant for partnerships and should be carefully considered and negotiated. Analyzing the definitions of taxable income and assumed tax rate in combination with determining when to make distributions should all be part of effective cash flow and treasury management.

Our High-Net-Worth team is here to help your organization with tailored tax planning strategies. Contact us below to get started.

For information about the tax implications of buying and selling in a partnership, read our related article.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.