Businesses pay income tax based on their taxable income. This means sole proprietorships and C corporations rarely pay tax without receiving cash. Exceptions exist—such as debt forgiveness, the sale of appreciated real estate, and a large difference between accrual and cash income.
Most cases of owing tax without receiving money—called phantom income—affect the owners of pass-through entities such as partnerships, LLCs, and S corporations.
Pass-through Income vs. Distributions
Pass-throughs rarely pay federal income tax directly. Instead, their income or loss flows through to the owners' returns via Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. Each owner then pays tax on their share of income or loss.
However, taxable income differs from distributions. Taxable income shows profitability for tax purposes. Money only reaches the owners of a pass-through via distributions. Because the owners already pay tax based on their share of the pass-through's income, distributions from pass-throughs usually create no tax liability.
Phantom income arises when a pass-through earns taxable income but decides not to distribute cash to owners. The usually occurs because owners want to use profits to grow the business. Also, income and distributions often fluctuate from year to year.
Why Do I Owe Taxes but Didn't Receive Cash?
Phantom income can cause hardship for owners. Consider the following circumstances:
- A and B form an LLC taxed as a partnership—a pass-through.
- A contributes most of the capital and receives a 60% membership interest, including profits and voting power. B contributes a little capital and will spend most of their time working in the LLC.
- The operating agreement requires a majority vote for any distributions.
- A receives income from many sources and primarily wants to grow the business. B relies on the new LLC for their entire income.
- B gets taxed at a 25% marginal rate.
- The LLC earns $200,000 of income its first year.
As a result, $80,000 of income ($200,000 x 40%) flows to B's tax return. This causes tax of $20,000 ($80,000 x 25%).
B expects to receive their $80,000 share of income as a distribution. This would leave $60,000 after income taxes—ignoring other potential taxes like self-employment.
However, A votes to make no distribution this year. From A's perspective, the LLC's business looks like a promising investment. Member A plans to use other income to pay the tax on their share of the LLC's income.
Member A controls more than 50% of voting power, so the LLC makes no distribution. B now owes $20,000 in taxes despite receiving no money. This could even force B into bankruptcy despite B's success in running the LLC.
Planning for Phantom Income
Business owners can avoid owing tax without getting a distribution by proper planning when setting up a pass-through. Carefully structured operating agreements—or bylaws for S corporations—can ensure that business owners avoid phantom income.
Operating agreements can require distribution of all taxable income, but that wouldn't allow owners to accumulate money in the business. Many LLCs and partnerships have operating agreements stipulating that all members must receive distributions of no less than their tax liability on their share of LLC income. Operating agreements can also mandate higher minimum distributions to ensure members can pay their bills.
S corporations need to exercise special caution in structuring distributions. Uneven distributions—in some circumstances—can cause the IRS to consider the S corp. as having multiple classes of stock, which would instantly terminate S corp. status. However, S corporations can still require minimum distributions provided that all shareholders have equal rights to distributions based on stock ownership. Also, S corporations must pay owners who work in the business a reasonable salary, which can help prevent phantom income.
Pass-throughs offer an attractive entity choice in many cases, but owners must beware of phantom income. Hiring a certified tax professional can help business owners plan for future tax consequences and structure operating agreements correctly. With competent tax planning, owners can avoid situations that cause them to owe tax despite receiving no money.