The phantom income problem is something just about every pass through entity (e.g., most LLCs, S corporations, and partnerships) has to deal with. A “pass through” entity is a business that doesn’t pay taxes at the entity level; instead business profits are passed through to the owners and taxed at the owner level.
The phantom income problem arises when profits are passed through to the owners only for tax purposes.
Related: Benefits Of S Corporation Tax Treatment For Washington LLCs
The Problem Defined
Phantom income is income that a business owner has to pay taxes on despite not having received any cash to pay the tax from the business. The phantom income problem arises because of the difference between allocating income to owners for tax purposes and distributing actual cash to the owners. Let’s dig into this difference.
When a business allocates an amount of income to an owner for tax purposes, the business is telling the IRS the amount owner should be taxed on. But—and this is the critical point—the business is not actually putting this amount of cash in the owner’s hand by doing this. Putting actual cash in the owner’s hand requires the business to distribute money to the owner, which is an entirely separate process.
Related: LLC Allocations v. Distributions: What’s The Difference?
So what, you might be thinking. The business will just distribute cash to the owner and there’s no problem. But unlike allocation of income for tax purposes, which must be done to keep the IRS happy, distribution of actual cash to owners isn’t neccessarily required, unless the owners of the business provide for this (typically in an LLC operating agreement, partnership agreement, or the like). Failure by a business to provide for this is the point at which the phantom income problem appears.
The Problem Exemplified
Let’s look at an example to illustrate this in action. Todd and Tina are the two owners of a Washington LLC, which is taxed as partnership and is therefore a pass through entity. At the end of the year, Todd and Tina is each allocated $100,000 of income from the business. Let’s say they each owe the IRS $25,000 in tax on this income. But Todd and Tina have decided not to distribute any income from their business for that year to themselves. As a result they’ll be paying taxes on income that they haven’t received, meaning they’re facing the phantom income problem. If they don’t have other financial means to pay this tax, they could be in a real bind. So, how do they solve for this problem?
The Problem Solved
One way to solve the phantom income problem is for the business to tie distributions to allocations. So, returning to our example, if the business tied distributions to allocations and Todd is allocated $100,000 of taxable income, then Todd will also receive a $100,000 distribution in cash. While this solves the phantom income problem, it may create a different problem. Namely, that the business is unable to build up cash reserves because all income is distributed to the owners.
To avoid swapping one problem for another, most businesses try to solve the phantom income problem by tying the amount of cash distributed to the owners to the amount of taxes they’ll owe. In other words, the business distributes enough cash to the owners for them to pay their share of taxes on the business income.
Our example is again instructive. If the Washington LLC tied cash distributions to taxes owed and Tina owed $25,000 in taxes, then Tina would receive a $25,000 cash distribution to pay her taxes but the remaining $75,000 of income allocated to her for tax purposes could be left in the business.
Tip: As a practical matter, tax distributions are typically made on a quarterly basis since owners will generally have quarterly estimated tax payment obligations.
With a little planning and some careful drafting, the phantom income problem is relatively easy to avoid for pass through entities. But make sure it’s addressed correctly in your agreement among the owners, whether it’s an LLC operating agreement, partnership agreement, or corporate bylaws. If you’re not confident in how to do this, or if you have a problem with overconfidence, get help from an attorney to get this right.