How to Avoid Phantom Income

Phantom income is income that is taxable to a taxpayer even though the taxpayer has not received cash to pay the tax. Phantom income is a common problem for LLCs and S corporations. This article explains phantom income and provides tips for addressing it.

How Phantom Income Arises

Phantom income results from a disparity between allocations and distributions. When income is allocated to a business owner for tax purposes even though the owner has not received a distribution of cash from the business, the owner must pay tax on income that the member has not received.

For passthrough entities—including partnerships, S corporations, sole proprietorships, and LLCs that use the default tax classification—income is taxable to the business owner when the income is earned, regardless of whether it is distributed. If there are multiple owners, the IRS uses allocation rules to ensure that each owner picks up his or her share of the business income.

Allocations are made at the business’s year-end based on the income that the business earned in that year. Allocations depend on the income the business earned, not on the income distributed to the member. A member is responsible for that member’s share of the company’s profit and losses—even if the member received no distribution from the company.

Phantom income can put business owners in a precarious position. They are responsible to pay income tax on the phantom income even though they have not received any funds from which to pay the tax. Without proper planning, the owners must pay the tax on phantom income from the owner’s other resources.

Planning for Phantom Income

There are several ways to plan to avoid adverse tax consequences from phantom income. For investors considering a business opportunity, adequate due diligence is essential. An examination of the business books and financial statements should indicate whether the business will generate a significant amount of phantom income. If it appears that the business will produce significant cash flow, the investor may want to be sure that a mechanism is in place to protect against phantom income.

Tax Distribution Clause

In the LLC context, the most common way to protect against phantom income is to include a provision—often called a tax distribution clause—in the operating agreement. A tax distribution clause requires the business to make distributions to cover the member’s tax liability from allocated income. Tax distribution clauses can be drafted different ways, but the goal is the same: to ensure that the member receives at least enough cash from the LLC to cover the member’s tax liability.

Because members may live in different states and have different financial situations, their tax liability for phantom income can vary. The members should decide on a uniform way to ensure that the tax distribution clause applies fairly to all members.

The LLC operating agreement could be drafted to apply a flat rate (say 40 percent) or to consider the member’s actual tax liability. Another way to ensure that no member pays out of pocket for allocated income is to ensure that each member receives an amount sufficient to pay the tax rates paid by New York City residents. This works because New York City has some of the highest tax rates in the country.

Similar tax distribution clauses can also be used in partnership agreements (for partnerships) and shareholder agreements and bylaws (for corporations).