The Risks of Phantom Income and Phantom Tax - FAQ
Originally posted on our CPA Eats Blog and reproduced here in its entirety.
An issue that often arises when using a passthrough entity is phantom income. Often a problem for LLCs, S Corps, and partnerships, phantom income occurs when the business entity reports a yearly profit, yet the owner or investors in the business do not receive cash reflecting the allocation. The IRS still taxes the full amount of the business’s income, making business members responsible for paying tax on income they have not received.
What is Phantom Income?
Quite simply, phantom income is a tax liability for a partnership or individual on income that has not been distributed to them.
How Does Phantom Income Occur?
Phantom income can come into play in a variety of circumstances, but we see it most commonly when a business is profitable but growing, a situation where a company will want to reinvest its profits into further growth.
Okay, Be More Specific…
Here’s a real world example: You’ve invested in ABC, LLC, which is taxed as a partnership, and you own 50% of the membership interests. At the end of the fiscal year, the LLC reports net profits of $200,000. Hooray! Wisely committing to growth, the managers of the company have decided those profits are needed to grow the company, thus they won’t be making any distributions to owners. As a member you’ll still receive a K1 that allocates $100,000 (50% of the net income) to you. Despite not having received any money, you’ll still be responsible for paying tax on that $100,000.
Yikes! What Do I Do About It?
Unfortunately for our character in the above example, it’s important to thoroughly plan ahead and exercise due diligence with any business opportunity. Harmony Group can tell at a glance from a business’s books whether there is a risk of significant phantom income.
With any passthrough entity, you should strongly consider adding a tax distribution provision to your operating agreement or shareholder agreement. This is a clause requiring a company to distribute at least some amount of any reported profit to its members or partners - a percentage allowing members to pay their tax bill.
Okay, Tax Distribution Provisions, Got It. For How Much?
It’s often recommended this amount equal the highest combined marginal rates that any member is taxed at, but we recommend setting it as a flat rate - 40%. This is for simplicity’s sake, as members may live in states with different tax laws or themselves have different financial and tax situations. A flat rate of 40% ensures that at the end of the year when you have $100,000 of taxable income as in the above example, the partnership will send you 40%, or $40,000, allowing you to cover your tax bill.
Sounds Great. Sum It Up For Me?
As a member or owner of any passthrough entity, it’s important to plan ahead for phantom income by adding a tax distribution clause to your operating agreement. This clause requires the business to make distributions to cover tax liabilities on allocated but undistributed income. These considerations are most common for entities that are profitable but still growing. More to the point, Harmony Group can help determine whether phantom income is a significant risk for you and your business and help you plan ahead to avoid all sorts of unnecessary tax headaches.