Clarifying Restaurant Tax Profit and Loss Allocation Provisions When Bringing in New Investors

When the owner of a restaurant business or restaurant group decides to sell a portion of his equity in an operating partnership to a private equity firm, this can signal that a period of growth is coming for the company. This can be an exciting time for restaurant owners as it will bring in additional leadership, funding and expertise. On the flip side, this can also have a crucial impact on tax and loss allocations. Owners must pay close attention to the language often proposed or suggested in operating agreements for this kind of investment.

Usually, a partnership that is family owned or held by a small number of founding investors will have straightforward tax profit and 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.    

PE or private equity investors usually hold preferred units that pay a percentage yield on their capital investment annually until all of their capital is paid back; any unpaid yield accrues over time.  When the company has a liquidation event, private equity investors receive their unpaid yield first.  This can often be 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 Consequences    

Tax profit and loss provisions get more complicated once a private equity firm is involved, which often can look 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.” – Scott Aber CEO of AberCPA.

(**** refers to the liquidation section of a partnership 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 can mirror what would happen if the company sold its assets at book value, paid off all liabilities and distributed 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 restaurants that show tax profits, income is allocated first to preferred owners in order to account for their increased right to receive liquidating distributions due to any unpaid accrued yield on their preferred equity.  An entity’s common owners will usually share whatever income remains.   

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

So this is still sort of a grey area, as the IRS has not specifically addressed this issue in their published guidance, many restaurant tax professionals believe that 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.    

This can represent a challenging and difficult scenario because 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.  This can be hard for owners to wrap their heads around because owners effectively have to pay the 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 locations.    

Investor Scenario Planning  

If you are a restaurateur that has taken on investors or a part owner in restaurant management group, before jumping into a new or revised operating agreement with a private equity investor, make sure that the new preferred owners and the existing common owners all fully understand the tax allocation provisions to avoid surprises.    

Discuss the potential outcomes with a restaurant tax advisor to make sure the allocations are in line with the expectations of all parties involved.   

 

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