Treatment of tax distributions for investor IRR

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by a searcher from Brown University
in New York, NY, USA

1yr ago

Treatment of tax distributions for investor IRR

Are tax distributions to equity investors considered when calculating investor IRR? I've seen models, including the one linked to here (redacted), 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.

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reply by an investor 1yr ago
from University of California, San Diego in San Francisco, CA, USA

You can present it either way, but I believe most experienced individual investors prefer to not see tax distributions included in IRR's in equity CIM's.

reply by an intermediary 1yr ago
from The University of Chicago in Chicago, IL, USA

Excellent question. Most people do not address this topic. My answer below has been tested by many, many over 20 years.

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.