Debt-financed distributions for pass-throughs: how they work and when they make sense

When a pass-through business takes out a loan at the entity level and immediately distributes the borrowed funds to its owners, this is considered a debt-financed distribution. This maneuver gives the owners immediate liquidity without triggering a current tax bill, as long as they have enough tax basis to cover the distribution. It’s a savvy cash-out strategy that, when done right, defers taxes while preserving ownership. But the results depend heavily on the entity type and each owner’s tax profile.

Mostly a pass-through strategy

Generally speaking, debt-financed distributions aren’t attractive or particularly beneficial for corporate entities, like S or C corporations, because debt at the entity level usually doesn’t increase an owner’s basis and can even result in double taxation. While there are specialized techniques for extracting cash from corporations, those rules are outside the scope of this discussion. Here, we’ll focus on pass-through entities, like partnerships and LLCs taxed as partnerships, because they can pass both income and liabilities to their owners. 

When a pass-through borrows money, each owner’s outside basis (their tax basis in the entity) rises in proportion to their share of the debt. This increased basis then shelters the distribution from taxation, provided the owner’s post-debt basis still covers the amount distributed. It’s a clean way to unlock value from the business without selling equity or recognizing gain.

Let’s say Sarah and Michael each own 50% of an LLC. Going into the deal, their outside bases are identical at $150,000 apiece. The LLC closes a $600,000 term loan, non-recourse to the owners. Assume the loan is shared between them under the tax rules (often similar to their profit split when no one personally guarantees it). Each picks up $300,000 of debt, so their bases rise from $150,000 to $450,000.

The company immediately distributes the $600,000 of loan proceeds - $300,000 to each owner. A distribution is generally tax-free as long as it does not push the owner’s basis below zero, and here it does not: both their bases decrease to $150,000. No one recognizes gain; no equity is sold.

Sarah and Michael have both pocketed $300,000 in cash while still holding $150,000 of basis for future loss deductions or additional tax-free draws. When the LLC later repays the loan, each owner’s basis will decrease dollar-for-dollar with the repayment. If that eventual reduction would drive either of their bases below zero, a capital gain would be triggered. Thus, it’s important to plan repayment timing with the guidance of a tax advisor. 

Risks and pitfalls to consider

The strategy can unlock tax-efficient liquidity, but only when it stays inside well-marked guardrails; missteps could invite both tax and legal challenges.

Debt character

Some loans are considered “recourse,” while others are “non-recourse,” and this designation matters. Whether a business loan is recourse or non-recourse depends on who ultimately bears the economic risk of loss, not on what the term sheet happens to call it. The debt is typically considered recourse if at least one owner is personally liable beyond the collateral; otherwise, it is likely non-recourse. 

A recourse debt is allocated solely to the partner who provided the guaranty (or shared pro rata among multiple guarantors), so only that partner’s outside basis rises. A partner who doesn’t guarantee the debt might receive cash without enough basis and recognize a gain.

If, instead, the lender is limited to collecting the pledged business collateral rather than an owner’s personal assets, it’s generally considered non-recourse. Non-recourse debt is usually spread by profit-sharing ratios, so everyone’s basis rises in proportion to ownership. 

Bottom line: if you plan to make any debt-financed distributions, you should consult with your legal and tax advisors to ensure the loan terms match your financial circumstances and goals. 

At-risk limitations

Even if a distribution is tax-free on day one, the at-risk rules of §465 can claw back the benefit later. In short, the rule prevents owners from piling non-recourse debt onto a struggling business, withdrawing the loan proceeds, and then letting the entity sink. Only money you could truly lose, like cash you contributed or debt you personally guarantee, counts toward your at-risk amount. Non-recourse borrowing generally doesn’t add to this figure unless it’s for qualified real estate financing, so any future losses in excess of that amount are locked up as suspended losses.

Beyond the tax implications, creditors also have remedies to protect themselves. If the new debt leaves the company insolvent or unreasonably undercapitalized, a creditor may label the distribution a fraudulent conveyance and claw it back from the owners personally. 

The fix to these risks is relatively straightforward: run a solvency test before closing on a loan, document enough working capital to satisfy lenders, and schedule principal pay-downs so basis and at-risk capital never fall through the floor. 

Interest deductibility

Interest is deductible (or not) according to what the borrowed cash actually funds: 

• Business interest tied to day-to-day operations is fully deductible at the entity level (subject to the §163(j) limitation).
• Investment interest is deductible only to the extent of investment income.
• Personal use interest is not deductible.

When a pass-through borrows, then hands the proceeds to its owners, the default assumption is that the owners, not the business, decide how that cash is used. Under the interest-tracing rules in Temp. Reg. §1.163-8T, the expense therefore “follows the money” to each owner’s investment or personal bucket, where some or all of the deduction can disappear. If owners use the cash for investing, the interest may be limited to their investment income; if they use it for personal spending, it’s usually not deductible. 

Notice 89-35 offers a partial workaround. A partnership may elect to treat the interest on debt-financed distributions as business interest up to the amount of the partnership’s operating expenses for that tax year. Think of it as absorbing the loan’s interest with bona fide business expenses already sitting on the books, such as payroll, rent, and so on. The election re-tags a slice of the interest as an ordinary business expense, fully deductible at the entity level. Anything beyond that slice is still traced to the owners.

Let’s say your annual operating costs are $2 million. As long as your annual interest payments for the loan are less than $2 million, the 89-35 election should let you deduct the full interest expense at the entity level. However, if your annual interest expense is $2.5 million, the $500,000 of excess will be traced to each partner’s personal use of the cash. 

The election is made each year, is irrevocable for that year, and requires the business to disclose the re-allocation on every Schedule K-1. It won’t magically convert excess personal borrowing into a business deduction, but it can preserve a full interest deduction where the distribution does not exceed the entity’s operating expenses. 

For owners, the takeaway is simple: run the math before closing and cap the distribution (or build in an amortization schedule) so that the interest the business pays remains deductible, rather than leaking out as a partner-level after-tax cost.

Disguised sale rules

The IRS scrutinizes any deal that pairs an owner’s contribution of appreciated property with a quick cash distribution, even if the cash is funded by a new loan. If the distribution occurs within two years of the contribution, the regulations presume it’s a disguised sale, and the owner must recognize the built-in gain. Waiting more than two years doesn’t completely remove the risk, but the initial presumption drops, so the IRS must affirmatively show a disguised sale. 

To mitigate this risk, consider the timing of any contributions of appreciated assets to the business, ensuring you wait at least two years before taking a debt-financed distribution. If possible, secure the loan with pooled assets or future cash flow instead of an asset recently contributed by a specific owner. Document that the borrowing supports an operating need, like working capital, and not a pre-arranged payout to the contributor. Also, distributions that follow profit-sharing ratios and benefit all owners look less like a property sale and more like a bona fide recapitalization. 

Business impacts

A debt-financed distribution is more than a tax play; it reshapes the balance sheet. 

Your existing loan agreements likely cap leverage (debt-to-EBITDA) or require a minimum interest coverage ratio. Keep in mind that the new debt counts against those limits, so yesterday’s comfortable cushion can turn into a technical default or a “consent required” notice. Even if you stay inside the lines, you burn borrowing capacity you might need later. Some loans also restrict distributions, so carefully review all the fine print before making any distributions. 

From a financial reporting perspective, the transaction may require disclosure under ASC 460 if owners guarantee the new debt. ASC 460 guarantees may require a footnote, and, in some cases, a fair value accrual. 

And in the M&A world, over-leveraging through a debt-financed dividend may suppress valuation multiples, even if it offers a pre-exit payout for existing owners.

Due diligence

Debt-financed distributions can be a strategic tool for some owners of pass-through entities. When used thoughtfully, the strategy functions like a tax-efficient recapitalization. But it requires technical precision, legal scrutiny, and a clear-eyed view of the business’s leverage capacity. 

For business owners contemplating this move, due diligence is non-negotiable. You’ll need to model basis adjustments for each owner, mitigate the risk of disguised sales, track interest expense allocations, and ensure compliance with both loan covenants and solvency rules. 

If you’re interested in more personalized guidance about your pass-through business or liquidity options, please contact our office.