The tax is one investor's, the cash leaves one bank account: why splitting the net amount by share makes the other LPs pay 360,000 they do not owe.
Tax withheld on behalf of one investor is charged to that investor alone: the fund allocates the distribution by entitlement as if nothing were withheld, pays the tax out of that investor's share, and records the withheld amount as a deemed distribution to it. On an illustrative 20,000,000 distribution where 450,000 is withheld for one 20 per cent LP, that LP receives 3,550,000 in cash and 4,000,000 of distributions, and the other two receive their full 10,000,000 and 6,000,000. Deducting the tax from the total before splitting it would make the other LPs pay 360,000 of someone else's tax.
Worked in full in The Private Markets COO by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Withholding lands on the COO's desk as an operational problem rather than a tax one. The tax advisers decide whether an amount must be withheld, for which investor and at what rate. The fund administrator and the finance team then have to move the cash, book the capital accounts and explain the notice, and that is where it goes wrong. The rate and the taxable amount below are illustrative and nothing here is tax advice; what matters is the mechanics, which most limited partnership agreements describe in a single clause: amounts withheld for a partner are treated as distributed to that partner.
| Input | Value |
|---|---|
| Distribution from a portfolio company sale | 20,000,000 |
| LP A share (non-resident investor) | 20% |
| LP B share | 50% |
| LP C share | 30% |
| Part of LP A's share subject to withholding | 3,000,000 |
| Withholding rate, illustrative | 15% |
| Interest on tax advanced for a partner (LPA rate) | 9% |
For simplicity the GP and carried interest are left out: the distribution is split by the three LPs' shares of the investment. With a waterfall the same logic applies to each LP's share after its own waterfall run.
Step 1, allocate by entitlement, ignoring tax. LP A 20,000,000 × 20% = 4,000,000; LP B 10,000,000; LP C 6,000,000.
Step 2, compute the withholding on the investor it concerns. 3,000,000 × 15% = 450,000, 11.25 per cent of LP A's share.
Step 3, pay the tax out of that investor's share. LP A cash = 4,000,000 − 450,000 = 3,550,000. LP B and LP C are paid in full.
Step 4, book the capital accounts. LP A: distribution 4,000,000, of which cash 3,550,000 and deemed distribution (tax withheld) 450,000. Fund cash out: 19,550,000 to investors plus 450,000 to the tax authority, 20,000,000 in all.
In Excel, by investor row: entitlement =Dist*Share; cash =Dist*Share-Withheld; and a check that =SUM(Cash)+SUM(Withheld) equals the distribution.
| Investor | Entitlement | Tax withheld | Cash, right | Cash, wrong | Difference |
|---|---|---|---|---|---|
| LP A | 4,000,000 | 450,000 | 3,550,000 | 3,910,000 | 360,000 |
| LP B | 10,000,000 | 0 | 10,000,000 | 9,775,000 | −225,000 |
| LP C | 6,000,000 | 0 | 6,000,000 | 5,865,000 | −135,000 |
| Total | 20,000,000 | 450,000 | 19,550,000 | 19,550,000 | 0 |
Both versions pay out the same cash in total, which is why the wrong one survives a cash reconciliation. The difference only appears investor by investor: in the wrong version LP B and LP C fund 80 per cent of LP A's tax.
The harder case is tax the fund must pay for a partner when there is no distribution to deduct it from, for example on income allocated to a non-resident LP in a year without exits. In a US partnership, for example, section 1446 requires tax to be paid on a foreign partner's allocable share of effectively connected income whether or not anything is distributed, while US-source FDAP income allocated to a foreign partner carries a 30 per cent default withholding rate that a tax treaty may reduce; which regime applies, and at what rate, is for the tax advisers. Many LPAs then give the GP a choice: call the amount from that partner, or advance it and treat the advance as a loan to the partner, with interest, recovered from its next distributions. Suppose the fund pays 300,000 for LP A in March and the next distribution, 10,000,000, comes 275 days later.
Interest = 300,000 × 9% × 275 ÷ 365 = 20,342
Recovery from LP A's next distribution = 300,000 + 20,342 = 320,342
LP A's share of the 10,000,000 = 2,000,000; cash paid = 2,000,000 − 320,342 = 1,679,658
If the fund simply pays the 300,000 from its own cash and books it as a fund expense, every investor bears it by share: LP B 150,000 and LP C 90,000, 240,000 in all, for a tax that is LP A's alone. The interest matters less than the classification, but it is not nothing: 6,658 after 90 days, 27,000 after a full year.
| Rate | Withheld | LP A cash, right | Borne by B and C if spread | of which LP B | of which LP C |
|---|---|---|---|---|---|
| 10% | 300,000 | 3,700,000 | 240,000 | 150,000 | 90,000 |
| 15% | 450,000 | 3,550,000 | 360,000 | 225,000 | 135,000 |
| 30% | 900,000 | 3,100,000 | 720,000 | 450,000 | 270,000 |
Netting the tax at fund level. It happens when the distribution notice is built from the cash that leaves the bank account rather than from each investor's entitlement: the administrator sees 19,550,000 going out and splits it by share. The second, quieter mistake is booking the 450,000 as a fund expense or a reduction of proceeds rather than as a distribution to LP A. That understates LP A's distributions, and because the waterfall counts distributions, LP A keeps 450,000 more of unreturned capital accruing its preferred return, about 36,000 a year at an 8 per cent hurdle, paid in the end by everyone else and by the GP's carry. The capital account check in how to reconcile a private fund capital account statement catches it only if the deemed distribution line exists.
Calls, distributions and the capital account mechanics behind this are in the free workbooks for this case; the waterfall side of an allocation is worked in how a fund distribution is allocated among LPs on different terms.
Not when it is withheld for a specific investor. Most LPAs treat it as distributed to the partner concerned. Booking 450,000 withheld for one 20 per cent LP as a fund expense spreads it by share, so the other investors bear 360,000 of it. And if that LP's records show only its cash as distributed, its unreturned capital stays 450,000 too high, accruing about 36,000 a year of preferred return at an 8 per cent hurdle.
The LPA usually lets the GP call the amount from that partner or treat the payment as a loan with interest, recovered from its next distributions. In the illustrative case 300,000 advanced at 9 per cent for 275 days accrues 20,342, so 320,342 comes out of the LP's next 2,000,000 share, leaving 1,679,658 of cash.
Yes, under the usual deemed distribution clause. The LP is treated as having received its full 4,000,000 even though 450,000 went to the tax authority. That reduces its unreturned capital and preferred return in the waterfall exactly as cash would, and its distribution notice should show the cash and the deemed amount on separate lines.
This article is one calculation from The Private Markets COO. 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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