Before I can define
“phantom income,” I’ve first got to explain how “tax flow through entities” work. Basically, if you own at least part of a partnership, limited liability company or S-corporation, you get a a tax bill each year based on your share of the business’ profits. That bill comes in the form of a K-1 tax form, which shows your portion of the profits or losses.
So, if you own 40% of a company (for the entire tax year) that had $100,000 of profits in 2008, then you would get a K-1 for $40,000. If you only owned that 40% for half the year, your K-1 should report $20,000 of imputed income to you. You then have to report that income on your individual income tax return and pay taxes on that amount.
But wait! What if the company never paid you a distribution (a/k/a dividend) equal to your K-1 number? Or, what if the company only pays you $12,000, but your K-1 shows $40,000 of income? If that happens, you have have “phantom income.” So, even though you only received a distribution of $12,000, you have to pay income taxes on the full $40,000.
If you want to avoid paying taxes on “phantom income,” then you should consider an agreement among all the owners and the company requiring the company to distribute at least enough profits to cover the taxes on your “phantom income. When I draft these agreements for my clients, I like to include a provision requiring no less than 40% of the company’s profits to be distributed, which should normally be enough in distributions to cover the highest marginal tax rate on any one owner. I include an exception, in the event the company has anticipated cash flow issues, or is about to make a large expenditure and needs the cash.
If you fail to include such a provision in your agreements, then you run the risk that the majority owners might try to “freeze out” the minority owners by causing “phantom income” to be reported on the minority owner’s K-1, year after year after year. In that case, it actually costs money for the minority owners to own a share of a profitable company.