The clause that pays the general partner cash for tax on carry it has not yet received, worked year by year, and what happens if the fund then disappoints.
A tax distribution pays the general partner cash to meet the tax on carried interest it has been allocated but not yet paid. The usual formula is the assumed tax rate times cumulative taxable income allocated to the carry partner, less everything already distributed to it, with the payment credited against later carry. On an illustrative fund at a 40 per cent assumed rate the GP receives 14.4 by year 6, when the European waterfall owes it only 6.0.
Worked in full in How to Read a Limited Partnership Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Under a European, whole-of-fund waterfall the GP is paid carry in cash only once limited partners have had back their contributions and the preferred return. For tax, though, the partnership allocates realised gains to partners' capital accounts as they arise, and the carry partner is allocated its share of profit as soon as a hypothetical liquidation of the fund would pay it. The carry partner can therefore owe tax years before it receives a dollar. The tax distribution clause bridges that gap. It is short, usually sits in the distributions article, and moves real money.
An illustrative $400m buyout fund with a European waterfall and 20 per cent carry. The tax allocations come from the fund's tax return each year; the cash entitlement comes from running the waterfall. Figures are in $m.
| Year | Taxable income allocated to the carry partner | Cumulative carry owed by the waterfall |
|---|---|---|
| 3 | 18.0 | 0.0 |
| 4 | 9.0 | 0.0 |
| 5 | -6.0 | 0.0 |
| 6 | 15.0 | 6.0 |
| 7 | 4.0 | 40.0 |
Assumed tax rate in the LPA: 40%. Tax distributions are advances against carry. The loss in year 5 is an allocation of a write-off realised that year.
Each year the clause sets a cumulative target, compares it with the carry the waterfall would pay anyway, and distributes whichever is higher, less what has already gone out.
Cumulative entitlementt = max(carry owedt, rate × cumulative allocated incomet)
Cash to GPt = max(0, entitlementt − cumulative paidt−1)
Excel, row t: =MAX(0,MAX(C_t,Rate*SUM($I$3:I_t))-SUM($P$3:P_t-1))
| Year | Cumulative income | 40% of it | Carry owed | Cash to GP | Cumulative paid |
|---|---|---|---|---|---|
| 3 | 18.0 | 7.2 | 0.0 | 7.2 | 7.2 |
| 4 | 27.0 | 10.8 | 0.0 | 3.6 | 10.8 |
| 5 | 21.0 | 8.4 | 0.0 | 0.0 | 10.8 |
| 6 | 36.0 | 14.4 | 6.0 | 3.6 | 14.4 |
| 7 | 40.0 | 16.0 | 40.0 | 25.6 | 40.0 |
Three things happen. In years 3 and 4 the GP receives 10.8 against no carry at all. In year 5 the loss cuts the cumulative target to 8.4, below the 10.8 already paid, so nothing is distributed, but nothing is recovered either: the clause works one way. In year 6 the waterfall finally owes 6.0 of carry, which is swallowed by the advance, and the GP receives a further 3.6 to bring it to 14.4. At the end the carry of 40.0 is paid net of the 14.4 advanced, so the GP gets 25.6 and the total is exactly the carry it was owed.
Only time value. Without the clause the GP would receive 6.0 in year 6 and 34.0 in year 7. Discounted at 8 per cent, that stream is worth 23.62 today; the stream with tax distributions is worth 25.57. The clause moves 1.95 of value to the GP, 8.2 per cent of the present value of its carry, without changing the total.
Read the clause for the word cumulative. A clause that pays the rate times each year's positive income, without netting, pays 7.2, 3.6, nothing and 6.0 over years 3 to 6: 16.8 against 14.4. The 2.4 difference is tax on the year 4 income that the year 5 loss later offset.
Now suppose year 7 brings a loss of 26.0 instead of a gain of 4.0, so cumulative allocated income ends at 10.0 and the waterfall's final carry is 10.0. The GP has already received 14.4 and the year 7 target is 4.0, so nothing more is paid. The GP has been over-distributed by 4.4, and the only route back is the clawback.
Almost every LPA caps the clawback at what the GP received net of taxes. Everything turns on how those taxes are measured:
| Tax deduction measured on | Tax deducted | Clawback cap | Returned to LPs | LPs lose |
|---|---|---|---|---|
| Net income after later losses (10.0 × 40%) | 4.0 | 10.4 | 4.4 | 0.0 |
| Gross allocations before losses (36.0 × 40%) | 14.4 | 0.0 | 0.0 | 4.4 |
If the clawback deducts tax on the gross income once allocated, the deduction equals the tax distributions themselves and the cap falls to zero. The tax distribution becomes, in effect, non-returnable carry. The protective drafting asks for taxes "taking into account the tax benefit of any losses allocated", which brings the deduction down to 4.0. For how the clawback's own tax assumption interacts with escrow, see what a clawback actually collateralises.
The rate is a negotiated number, usually the highest combined rate applicable to any individual in the carry vehicle. It scales the advance in direct proportion.
| Assumed rate | Paid by year 6 | Above carry owed | Downside over-distribution | PV moved to GP |
|---|---|---|---|---|
| 30% | 10.80 | 4.80 | 0.80 | 1.39 |
| 37% | 13.32 | 7.32 | 3.32 | 1.78 |
| 40% | 14.40 | 8.40 | 4.40 | 1.95 |
| 45% | 16.20 | 10.20 | 6.20 | 2.23 |
The downside column grows faster than the rate: from 30 to 45 per cent the advance rises by half, the exposure more than sevenfold, because the exposure is only the part of the advance that final carry does not cover.
Reviewing the tax distribution clause on its own. Its cost sits in two other places: the waterfall clause that says whether tax distributions reduce later carry (if they do not, they are simply extra carry), and the clawback clause that says how taxes are deducted. Read the three together, and check that the clause uses cumulative income and reduces distributions by all prior amounts paid, carry included.
Chapter 11 of the book works the clawback, and the free workbook for this case carries the clawback, its tax rate and its escrow on one sheet.
In most LPAs, yes. They are treated as distributions of carried interest made early, so later carry is reduced by everything already paid. On the illustrative fund the GP receives 14.4 by year 6, mostly tax distributions, and 25.6 of carry in year 7, a total of 40.0, exactly the carry the waterfall owes. The cost to LPs is timing: 1.95 of present value at 8%.
Because a year-by-year clause ignores losses allocated in between. On the illustrative fund, taxing each year's positive income at 40% pays 16.8 by year 6, against 14.4 on the cumulative method, which nets the loss of 6.0 allocated in year 5. The 2.4 difference is cash the GP holds against income it was never finally taxed on.
Only to the extent the clawback is not reduced by tax. Most clawbacks are capped at amounts received net of taxes. If that tax is measured on gross allocations of 36.0, the cap on 14.4 received is zero, and the 4.4 over-distribution in the downside case is never returned. Measured net of later losses, tax is 4.0 and all 4.4 comes back.
This article is one calculation from How to Read a Limited Partnership Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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