The concept of sharing is ingrained in us at an early age. In preschool, I can still remember being told to share the classroom toys with my classmates. In the business world, however, the concept of sharing is sometimes cast aside by business owners and investors. In particular, when distributions are not shared equally (pro-rata) by investors, it can have an impact on the value of those ownership interests.
Oftentimes, when businesses make distributions of cash and other assets to their owners, the owners share in the distributions on a pro-rata basis relative to individual ownership percentages. Partnerships and LLC agreements will sometimes allow investors to distribute assets to investors “disproportionately,” although many partnership agreements call for these disproportionate distributions to be cured at some later date (such as upon winding up of the business or the sale of the ownership interest). If an ownership interest in an entity that has made disproportionate distributions in the past is being valued, it may be necessary to consider the resultant impact on value.
For example, assume Jeff owns a 75% ownership interest in Lake Partnership and Tom owns the remaining 25%. Last year, Jeff paid a $1,000,000 distribution to himself (which he was able to direct as the controlling owner), but made no distribution to Tom. In this case, Jeff has “overdistributed” $250,000 to himself and Tom has missed out on this amount. If it were necessary to value Jeff’s interest, the valuation expert would need to take into consideration the fact that Jeff effectively “owes” Tom $250,000 for the disproportionate distribution that Jeff received, which would lower the value of Jeff’s ownership interest. Conversely, if we were valuing Tom’s 25% ownership interest, it would be necessary to consider the $250,000 effectively “owed” to Tom from Jeff as a result of the disproportionate distribution.
While not terribly common, disproportionate distributions are sometimes made in partnerships and limited liability companies. If disproportionate distributions occur within an S Corporation, there can be issues beyond the impact on the value of the ownership interests – disproportionate distributions are strictly prohibited for S Corporations and can “bust” the company’s S election (meaning that taxes will be levied at the entity level rather than at the shareholder level). If an S Corporation makes or has made disproportionate distributions, it is imperative that the distributions be “trued-up” in accordance with the investors’ ownership percentages to minimize the likelihood of the company’s S election being revoked.
As discussed above, when investors do not share equally (pro-rata) in distributions, it can impact the value of the various ownership interests and create the potential for significant tax-related issues if the entity is an S Corporation. Just as when we were learning to share as children, not following the old adage of “share and share alike” can result in unintended consequences.
To learn more about the impact of disproportionate distributions, leave a comment below, or contact Sean Saari in Skoda Minotti's Business Valuation Services Group by calling 440-449-6800.