Most private company investors are not tax experts, but developing a working knowledge of the potential for the business to generate phantom income is critical to avoiding unwelcome, tax consequences. What is phantom income exactly, and why does it matter? This Blog post focuses on answering that question to avoid ghoulish tax surprises appearing after Halloween.
What is Phantom Income
As a starting point, most private companies are pass-through entities for tax purposes, and they therefore have the potential to generate phantom income for their owners. That is because the company does not pay any tax on its profits, and the owners of the business must pay all of the taxes on income generated by the business. Therefore, the problem of phantom income arises when the company reports its income to the IRS, but does not actually distribute any money to the owners. In this situation, the owners have to pay the tax on the reported income, but they have not received any cash to pay the amount of the tax now due to the IRS.
Why Is Phantom Income Allocated to Business Owners
The problem of phantom income seems easily avoided – if the company simply distributes all of the profits that it generates to its owners, they will have ample cash to pay the taxes that are due on these profits. The question then becomes, why would a company ever fail to distribute to its owners sufficient cash to allow the owners to pay the tax on the company’s profits. The answer is that a company may have many valid business reasons to retain all or most of its profits.
The reasons that businesses will want to retain earnings include, but are not limited to all of the following: (i) the company wants to retain working capital to protect against an anticipated downturn in the business, (ii) there may be significant capital expenditures to invest in growth by building new facilities, acquiring new inventory and buying new patent license rights, (iii) the business may be self-insured and need to retain sufficient funds to maintain an insurance reserve, (iv) the company may be planning for an acquisition and need funds to pay some or all of the purchase price for the new company, and (v) the company may be expanding and need funds on hand to incur the significant costs that are associated with the expansion into new national or international markets.
All of these reasons for retaining earnings make business sense and are designed to enhance the long term value of the company. Indeed, as the company retains its earnings, the value of the owner’s stock in the business is likely to increase, because the company as a whole is becoming more valuable due to these strategic business decisions. But in the short term, the owner will be issued a K-1 reflecting the owner’s portion of the company profits on which tax must be paid even when the owner is not receiving any actual cash distributions or when the amount of the cash distributions is too small to cover all of the taxes allocated to the owner based on the percentage held by the owner in the business. The net effect is that the owner has to dig into his or her own pocket to pay taxes attributable to his/her ownership percentage in the business.
Avoid Being Surprised by Unexpected Phantom Income
Majority owners who control their private companies are typically given very broad discretion as to whether to declare and issue distributions. They are therefore in a position to decide whether they want to avoid a phantom tax problem or whether, in their business judgment, the short term pain of phantom income is offset by the projected, long-term growth in the value of the business.
For minority investors in private companies, however, there are two situations they will want to address to ensure that they are not surprised with a huge, unexpected phantom tax liability. These two situations take place at the time they make their investment in the company and at the time they exit and sell their interest in the business. At the time that a minority investor makes his or her investment in a private company, the investor will want to ensure that the LLC Agreement, the LP Agreement or the bylaws of the company include a provision that requires the company to make a distribution (or dividend) that, at a minimum, will be sufficient to cover the taxes on any income that is allocated to the investor based on his or her ownership interest in the business. This is commonly referred to as a “tax distribution provision,” and it is critical to obtain this type of commitment from the company to ensure that the investor actually receives cash distributions rather than becoming saddled with crippling phantom income tax bills.
The second situation, at the time of exit, is to require the company to agree it will not allocate any income to the now former investor in a future K-1, or alternatively, that it will not allocate any income to the former investor that exceeds the amount of cash that was actually distributed to the investor during the time he or she owned her interest in the business. For example, if the investor sells his or her ownership interest in the company before the end of 2017, the investor will receive a K-1 from the company in 2018 based on the investor’s past ownership in the business during 2017. If the investor does not secure a provision addressing this issue in the transfer/purchase document, the company may issue a K-1 to the former investor that reflects a sizable phantom tax liability based on the investor’s previous ownership in the business during 2017. It is therefore critical for the investor to obtain a provision from the company at the time of exit that either fully eliminates or caps the amount of the income the company allocates to the investor in 2018 based on the investor’s former ownership interest in the company.
Investing in private companies is challenging enough without being exposed to the threat of an unexpected tax burden. To avoid experiencing a post-Halloween scare in the form of a large tax bill that was not expected, investors cannot simply turn over tax issues to their accountants to handle. If investors fail to secure a tax distribution provision when they invest in the company, their accountants will not be able to fix the phantom problem for them after-the-fact. That is also true when investors exit the business. In the absence of a provision that protects investors from being hit with phantom tax liability based on their past ownership in the business, investors may not be stuck with a large tax liability when a K-1 is issued to them the following year allocating a substantial amount of phantom income based on the investors’ former ownership in the business. In short, some advance planning by investors will help keep the tax goblins at bay.