One of the most attractive qualities of LLCs, S corporations, and partnerships is the “pass-through” taxation that minimizes the tax burden for entrepreneurs. This avoids double taxation that applies to traditional corporations. In reporting the pass-through income, owners (and part-owners) must complete the Schedule K-1 tax form each year. This logs the income, deductions, and losses from the business that each individual is allocated.
An issue that may arise when using a pass-through entity is phantom income. This occurs when the business entity itself reports a yearly profit, yet the individual or individuals to which a percentage of that profit is allocated do not receive the cash reflecting that allocation. That disconnect is not consequential for the IRS, which demands its tax payment related to the entity’s profit from the owner (not the entity) regardless of whether it is distributed to individuals.
What Causes Phantom Income?
There are a variety of situations in which phantom income may come into play. But the most common set of facts causing phantom income arises when a pass through entity (e.g., S corporation, LLC taxed as a partnership, or a partnership) is profitable but growing. In this situation, it’s very likely that the Company needs to re-invest its profits into further growth.
Here’s an example. Let’s say that you are an investor in ABC LLC (which is taxed as a partnership) and you own 20% of the membership interests. At the end of the most-recent completed fiscal year, the LLC reports net profit of $200,000. But, the managers of the Company have determined that those profits are needed to grow the company (whether through expanding the marketing efforts, making some hires, further developing the products, etc., etc.) and, therefore, won’t be making any distributions to its owners. You as the investor will receive a K-1 that allocates $40,000 (i.e., 20% of the net income) to you as income. But, you didn’t receive any money and, despite that, you still have to pay tax on $40,000.
What Can Be Done About Phantom Income?
If you’re an investor, shareholder, member, or partner in a pass-through entity, you should strongly consider adding a “tax distribution” provision to your operating agreement or shareholder agreement. This will help protect against or mitigate the effects of phantom income. This clause will require that, when the company reports a profit, at least some amount of that profit will be distributed to members or partners. Often, you might set some percentage of profit that will be distributed (e.g., a marginal tax rate) to the Members so that they can pay their tax bill. The current highest federal marginal tax rate for individual taxpayers is 37% (note that this does not include state income tax rates).
Using the example from above, if we had a tax distribution provision requiring distribution of at least an amount equal to 37% of the profits, then the Company would need to distribute a total of $74,000 to its partners (and $14,800 to you, the investor holding 20%). But, that also means that the Company’s re-deployment of profits is reduced from $200,000 to $126,000. So, the operators of the business need to give consideration to this.
Sometimes, where large amounts of profits are expected to be retained, clients may find better tax efficiencies in a C corporation (despite its “double taxation” features), as the tax rate for C corporations is currently 21%. So, under the same set of facts as above (except using a C corporation), the company would pay the tax (it would not flow through to investors unless there is a corresponding distribution of cash). In this case, the total tax would only be $42,000 and the company would be able to retain and use $158,000 of its profits.
There is not a complete avoidance of tax issues with pass-through entities. Phantom income can cause a larger tax bill for certain business stakeholders than is planned for, especially if the company needs to fund rapid growth.
It’s important to go through the exercise of thinking these issues through and making a plan. It’s also important to make sure that you are operating the company in the appropriate form (i.e., LLC, S corporation, or C corporation).
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