Generally, absent an agreement to the contrary, there is no requirement that a business make distributions to its owners.  This and most all other decisions are controlled by the majority. 

A shareholder agreement should address how distributable cash flow, which is not limited to profits, should be determined and how profits and losses are allocated among the partners.  The Internal Revenue Code contains myriad requirements addressing the allocation of profits and losses that must be considered when drafting these provisions. 

How and When is Distributable Cash Flow Determined and Distributed?

Of paramount importance to the partners is defining the expectation of how and when distributable cash flow is going to be determined and distributed. In many early-stage enterprises, there is not expectation that profits will be distributed.  Instead, the understanding is that they will be used to further invest in the business. The opposite may be true for more mature businesses.

Flow-Through Entities

Most privately-held businesses are formed as flow-through entities (partnerships, limited liability companies or s- corporations).  What this means is that there is only one level of taxation and it is at the owner level.  It is important to note that in these flow-through entities, the income and losses flow through and are taxed to the owners whether or not money is distributed to the partners. Partners allocate a share of a business’s taxable income without a distribution experience what is commonly referred to as “phantom income” – tax liability without money to pay the tax.  A shareholder agreement often addresses this issue by requiring the company to distribute at least enough to the owners to pay their tax liability subject to there being satisfactory cash flow to do so.  How and who determines if there is satisfactory cash flow to do so should be addressed.  Remember, absent a provision dealing with this issue, there is not requirement that a partner receive a distribution or profits – just that if there is a distribution, it be made in proportion to ownership interests.

Partners frequently have disparate cash flow requirements and they should address these expectations in the shareholder agreement.

Passive vs. Active Owners is a Consideration

Frequently business have both passive and active (owners that work in the business) owners. Active owners will predictably have different expectations regarding entitlement to cash flow.  If the active partner(s) received some or all of their interest in the business in exchange for future services, this adds another level of complexity.  Often, working partners receive priority distributions to compensate them for their services.  These are sometimes referred to as “guaranteed payments.” 

There are often different classes of ownership interests in business entities with different entitlements to cash flow.  The provisions in a shareholder agreement dealing with the priority to distributions of cash flow are often referred to as the “waterfall’ provisions.  Even where there is only one class of ownership interest in an entity, these waterfall provisions must be clearly set forth in the agreement.  For example, if a partner loans money to a business, is the loan prepaid from available cash flow before any regular distributions or perhaps guaranteed payments to partners?

When Will the Business Return Contributed Capital to the Partners?

Lastly, partners should address under what circumstances will the business return contributed capital to the partners. In many cases the expectation is that this will only occur if an when the business is sold or when a partner sells her interest in the business.  As will all aspects of the business agreement among the partners, it is strongly recommended that the expectations of the parties are clearly set forth in a shareholders’ agreement rather than presuming that everyone is and will remain on the same page. At Lex Nova, we help businesses make decisions regarding partnership distributions. Contact a corporate lawyer at our law firm today for more information.