Return ON capital VS. Return OF capital in syndications

[Kyle Kovats]

How are your syndications OA's structured, return OF or return ON capital? 

Here is an example, 

7.3. Distributions of Net Cash Flow. The Company shall distribute Net Cash Flow as follows:
(a) First, an amount, if any, to the Members for any Additional Capital that they may have contributed.
(b) Next, in the Managers’ sole discretion, to the Class A and Class B Members in an amount representing the return of all Capital Contributions of the Class A and Class B Members. 11
(c) Lastly, to the extent remaining, eighty percent (84%) to the Class A Members, to be distributed to the Class A Members in accordance with their respective Percentage Interest in Class A, and twenty percent (16%) to the Class B Members, in accordance with their respective Percentage Interest in Class B.


Are there any tax advantages to structuring this as a "return of capital" as opposed to a "return on capital" during the hold period? This way you're only hit with a taxable event at time of sale from the large capital event since the distributions during the hold are just technically a return OF your capital. However, this would not work out so well if the market were to drop on the back end. Would love to hear some opinions on this one

[Brian Burke]

Distributions and income are not the same thing—so you can call the distributions anything you want and it won’t change the amount of tax the investors will pay, nor when those taxes will be due.

In most cases my operating agreements are worded to distribute the preferred return first, followed by other return ON capital.  Return OF capital is either only capital events (such as cash-out refinance or sale), or next after the pref but before other Waterfall tiers.

The reason I don’t usually do return OF capital first is because each distribution would reduce the investor’s capital balance, which in turn reduces the preferred return due for the next period. This is favorable to the sponsor but not to the investor.  We sponsors have enough advantages, so whenever I can make a simple decision that favors the investor, I will.

If your waterfall is calculated on IRR split tiers instead of an annual return, the order is moot because "return of" and "return on" are treated the same, without any distinction, simply by definition.