Understanding Tax Profit and Loss Allocation Provisions that PE Investors Bring

When the owners of a restaurant company sell a portion of the equity in their operating partnership to a private equity firm, it signals a period of upcoming growth for their company. While it is exciting for the restaurant owners to bring in this additional funding and expertise, it can also have a significant impact on the tax profit and loss allocations. Owners must pay close attention to the language often proposed in operating agreements for this type of investment.

Typically, a partnership that is family-owned or held by a small number of founding investors will have very straightforward tax profit and loss allocation provisions: owners share in the profits and losses of the entity based on the proportionate amount of units they each hold to the total units of ownership in the entity. 

Private equity investors typically hold preferred units that pay a percentage yield on their capital investment annually until all of their capital is repaid—any unpaid yield accrues over time. When the company is liquidated, private equity investors receive their unpaid yield first. This is often followed by a repayment of any unpaid portion of their preferred equity contribution; only then will common unit holders receive a payout.

Understanding the Tax Impact

Tax profit and loss provisions grow more complicated once private equity firms get involved, often looking something like this:

“For each fiscal year (or portion thereof), except as otherwise provided in this agreement, Net Income or Net Loss (and, to the extent necessary, individual items of income, gain, loss or deduction) of the Company shall be allocated among the Members in a manner such that the Capital Account balance of each Member, immediately after making such allocations, is, as nearly as possible, equal to the Distributions that would be made to such Member pursuant to Section **** if the Company were dissolved, its affairs wound up and its assets sold for cash equal to their Book Value, all liabilities paid off and net assets of the Company distributed.”
(**** refers to the liquidation section of an agreement)

These types of tax allocation provisions are commonly known as “targeted capital account allocation provisions.” Instead of allocating income based on straight ownership percentages, each partner’s ending capital account must hit a “target” that is equal to the amount the partner would receive upon the company’s liquidation. Essentially, this mirrors what would happen if the company sold its assets at book value, paid off all liabilities and distributed out final cash. The amount of profit or loss allocated to each owner equals whatever amount is needed to get from the ending target from the previous year to the ending target in the current year.

For companies that show tax profits, income is allocated first to the preferred owners in order to account for their increased right to receive liquidating distributions due to any unpaid accrued yield on their preferred equity. The common owners will typically share whatever income remains. 

For companies that show tax losses, often due to large amounts of depreciation in the restaurant industry, the allocations get more challenging. Because the accrued yield owed to preferred owners increases every year that it goes unpaid, their ending “target” capital account also increases because that additional yield is due to them at a liquidation event. In other words, they cannot be allocated a loss because their target has gone up, not down.

While the IRS has not specifically addressed this situation in published guidance, many advisors believe that the preferred unit holders must receive an allocation of gross income in a year of tax loss; this results in allocating losses to common unit holders in excess of the partnership’s net loss for the year. It presents a challenging situation: most operating agreements require that tax distributions are paid out to cover tax obligations. In this example, a tax distribution would need to be made because of taxable income reported by preferred owners, even though the company is in a loss position. It is difficult for owners to wrap their heads around the fact that they effectively have to pay the new investors to help those same investors pay tax on gross income allocations, at a time when the company has a net tax loss and potentially negative cash flow due to investment in new stores.


Scenario Planning

Before diving head-first into a revised operating agreement with a private equity investor, make sure that the new preferred owners and the existing common owners all understand the tax allocation provisions to avoid surprises. Discuss the potential outcomes with a tax advisor to make sure the allocations are in line with the expectations of all parties involved.

For more on tax profit and loss allocations, contact Jeff Tubaugh at [email protected]. And be sure to keep up with our practice’s latest thoughts by following us on Twitter at @BDORestaurant.