Tax distributions to investors

Tax distributions are a common expectation of investors in any entity that has "pass through" taxation, which includes an LLC taxed either as a partnership or as an S corp.

(An S corp is rare in ETA context if you're taking on investors since you can't pay preferred returns to some investors in an S corp. Most acquisition entities are taxed as partnerships, with some as C Corps. If you're self-funded, you can consider an S Corp.)

Tax distributions are not "meant" to change the economic allocation, they are meant to give owners the funds necessary to pay tax on the income they get allocated to them from the company. They are generally regarded as an "advance" on future distributions and so reduce the given partner's next distribution.

So if you have a preferred distribution, but the tax distribution takes precedence, you'd first pay the tax distro than return to the preferred distribution waterfall and credit any tax distros to the recipient's next preferred (or regular) distribution.

(That said, in practice, a tax distribution gives someone money today, and if that money is more than they would have otherwise gotten, and tomorrow there's no more money, it can end up causing a shift in the economics. Hopefully, there's enough cash that it all straightens out at the end.)

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Tax distributions are based upon your operating agreement. Typically, they say you are supposed to do a distribution at the highest tax rate of your investors so that they can pay their taxes but sometimes there is also a defined percentage that will be distributed for taxes. The reason for this is to avoid the investors being allocated net income and having to pay taxes on it without receiving any cash. You mention an S-Corp which would mean that all distributions must be pro-ratable to ownership percentage an would not have any preferred distributions (would revoke your S-Election if you did).

If this was a regular LLC with a waterfall agreement and preferred distributions then most of the times the tax distribution are calculated before the preferred distributions and the waterfall but I have seen operating agreements treat these differently. Would really come down to how that is written.

A little confused as I read these replies as there are lots of references to a C-Corp which isn't referenced in the question I am seeing so not sure if I am missing something.

For clarity I am a CPA and not a lawyer. As always when something is very dependent upon the way the operating agreement is written, I would recommend getting a lawyers opinion on your agreement.