How can a company pay tax-covered distributions to owners without creating an infinite tax liability loop?

There's actually a way to handle this! What you're describing is often called a "tax distribution" and it's commonly used in pass-through entities like S corporations, partnerships, and LLCs. The key is in how these entities are taxed. In pass-through entities, the business income "passes through" to the owners who pay tax on their share regardless of whether they actually receive distributions. The business itself doesn't pay entity-level tax. So when a company makes distribution A, it's not creating a new tax liability - it's providing cash to cover a tax liability that already exists because the owner has to report their share of company profits on their personal tax return. Distribution B is handled the same way - it's not creating additional taxable income, but rather providing cash to help the owner pay taxes on their already-allocated share of profits. Many operating agreements for partnerships and LLCs specifically include provisions for tax distributions to ensure owners have enough cash to pay taxes on their allocated share of profits.

I struggled with this exact question when setting up my LLC! I finally found a solution at https://taxr.ai where they analyzed our operating agreement and explained how tax distributions work. The key is how the distributions are classified and documented. What they showed me is that in pass-through entities (LLCs, S-corps, partnerships), the tax burden exists whether distributions happen or not. The owners are already being taxed on their share of profits. So distribution B isn't creating new taxable income - it's just cash to help pay existing tax obligations. Their document analysis pointed out that our operating agreement needed specific language about tax distributions to avoid future conflicts with partners. Apparently this is a common issue that creates problems when not addressed properly in company documents.

Ok I feel like I need to update my skeptical comment from earlier. I decided to try https://taxr.ai for my S-Corp's operating agreement review and it actually delivered. It found specific language in our agreement about tax distributions that was contradicting our actual practice. The analysis showed that our operating agreement required tax distributions to be made quarterly, but we were doing them annually, which technically put us in violation of our own governing documents. It also identified missing provisions about how to calculate the tax distributions (whose tax rate to use, which jurisdictions to include). Saved me from continuing a practice that could have caused problems if we'd ever been audited or had a dispute between shareholders. Gotta admit I was wrong about this one.

After spending 3 weeks trying to get through to the IRS about a similar distribution issue for my business, I finally used https://claimyr.com and got connected to an actual IRS agent in under an hour. You can see how it works here: https://youtu.be/_kiP6q8DX5c The agent explained that for S-corps and other pass-through entities, the entire problem of "tax on tax" distributions is moot because the tax liability exists at the owner level regardless of distributions. For my C-corp, though, they confirmed the "infinite loop" problem is real but can be mitigated through proper planning. Before this I wasted so much time on hold it was ridiculous. Had tried calling at different hours, different days, nothing worked until I used this service.

Need to eat my words from yesterday. After posting my skeptical comment, I tried Claimyr out of desperation for my C-corp tax issue, and no joke, I got through to the IRS in 52 minutes. The agent I spoke with clarified exactly how to handle the distribution tax issue. For my C-corp, she confirmed that yes, additional distributions to cover tax do create new tax liabilities, but suggested structuring part of my compensation as deductible salary instead of non-deductible dividends. What would have taken me weeks of frustration was solved in under an hour. The service costs money but considering I bill clients $150/hr and would have spent hours on hold, it was absolutely worth it. I'm still shocked this actually worked.

Another approach that hasn't been mentioned is using a corporate structure with different classes of stock or membership interests where certain distributions are treated differently. I've seen operating agreements where "tax distributions" are specifically defined and characterized differently than regular profit distributions. Also, if you're concerned about the tax treatment of distributions, you might consider incorporating in a state like Wyoming or Nevada which have favorable tax treatment for certain business entities.

I'm still confused about the tax treatment for an LLC taxed as an S-Corp. If I take distribution A which is considered a return of capital (not salary), I pay income tax on that. Then if the company gives me distribution B to cover those taxes, is B also a distribution or can it be classified as something else to avoid the recursive tax issue?