Those small businesses using partnership or S-Corporation formats issue Form K-1 to the respective owners. When income is assigned to the owner and there is no corresponding cash related to that income, then this income is referred to as ‘Phantom Income’. In effect, it is assigned income for tax purposes without the corresponding cash to pay the tax liability.
What types of entities generate ‘Phantom Income’? How does an owner of a business get into this situation? Is it possible to alleviate or offset this tax liability? The following sections answer these questions and provide guidance for the taxpayer in addressing the tax obligation.
Phantom Income Generators
There are several different entities that generate phantom income for their owners and investors. The most common entity is the S-Corporation. Others include:
- Limited Liability Companies
- Tax Shelter Partnerships
Similar in nature to a W-2 where both the Internal Revenue Service and the employee receive an earnings statement, the entity reports to the IRS via the tax return and the corresponding K-1 who the owners are and their corresponding assigned amounts of income. Of course, the W-2 reflects actual cash income the employee received during the tax year. Whereas with the K-1; the income may or may not reflect actual cash earned by the owner. Typically, the income is reported in blocks 1 through 10. See the screen shot below of an 1120S K-1.
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The key to this document is that both the IRS and the taxpayer receive a copy of the document. Therefore, the IRS expects the taxpayer to report this income on their personal tax return to the correct corresponding forms and schedules. As an example, Line 2 would reflect income from rental property and thus this information should be included on the taxpayer’s Schedule E which identifies income from rental sources along with other entities.
The entities identified above are commonly referred to as ‘Pass-Thru’ entities and therefore their respective net earnings from the various forms of income are passed through to the respective owners. Typically pass through entities DO NOT PAY TAXES as this obligation falls to the respective owners or beneficiaries. The following is a chart identifying the respective title of the owner for each of the various types of entities:
Type of Entity Reporting Form Title of Taxpayer
Partnership 1065 K-1 Partner
Limited Liability Company 1065 K-1 Partner (See my note below)
Trust 1041 K-1 Beneficiary (See my note below)
S-Corporation 1120-S K-1 Shareholder
Estate 1041 K-1 Beneficiary
Tax Shelter 1065 K-1 Partner
* Note to Title of Taxpayer related to Limited Liability Company; Entity may be granted status as an S-Corporation which changes the title to Shareholder.
*Note to Title of Taxpayer related to Trust: The original owner is referred to as the Grantor, once the trust becomes irrevocable, then the grantor is no longer the owner, the beneficiary becomes the owner. For information related to trusts, read the following article: Trusts
Each of the above entities must receive permission from the Internal Revenue Service to exist. To get that permission some legal document triggers the right to seek permission from the IRS for pass through tax status.
Each of the respective entities is created out of a legal document. The following is a brief description of each and their corresponding legal document:
- Partnership – an agreement between two or more parties to join together to achieve a business objective. The legal binding agreement is a partnership agreement and posting of this agreement with the local circuit court or via the secretary of your state (each state is different in how they recognize this type of entity) grants legal status.
- Limited Liability Company (LLC) – similar to a partnership, several individuals get together to form a business operation, the partners are referred to as members with the exception of the IRS documents where they are referred to as partners. An LLC creates a membership agreement setting out the respective duties and obligations of each one of the members. Often, several members will have no obligation other than a passive capital contribution position.
- Trust – there are two types or groups of trusts. The more common is the revocable which means the IRS will not recognize them for tax purposes as there is no binding arrangement. The second type of trust is irrevocable and therefore a binding arrangement exists. This binding arrangement is often called the trust documents and each state uses a different method to legalize the documents. The most common method is via a court order or court recognition. Often trusts exist due to death of the grantor or exist due to a court order as a result of some class action lawsuit. Those receiving value from the trust are referred to as beneficiaries.
- S-Corporation – incorporated in the state where legally domiciled, corporations are typically governed by a set of By-Laws. Most states use the Secretary of the State (a state level position) via their respective departments of revenue to grant a charter to a corporation. The S-Corporation status is a mere request made to the IRS to be granted the rights under Sub-Chapter S of the code and be treated as a non-taxed business entity whereby the respective shareholders are assigned the income.
- Tax Shelters – this is most often a large partnership recognized by the Securities and Exchange Commission and the entity sells its ownership rights throughout the country. The most common tax shelters are large real estate holdings or oil companies. The legal document is the granted rights as recognized by the SEC.
- Estates – upon death, if the deceased has a minimum level of wealth (usually more than $10,000) the courts order the executor or administrator of the estate to carry out the orders in the trust document or will of the deceased. A temporary estate is created whereby the trustee (executor/administrator) must gather all sources of income and then disperse this income and the corresponding underlying assets to the beneficiaries. While this is ongoing, the estate acts like a business entity and files a tax return with the IRS. The beneficiaries are the recipients of this information and ultimately the respective value.
All of the above entities with the exception of the estate require the owner to agree to participate in the business relationship. The estate entity does not require a signature by the beneficiary as owner; however, it is uncommon for the courts to restrict disbursements to the beneficiaries to pay the tax liability of the estate. The courts understand that tax liabilities must be paid in cash and therefore it is rare for the courts to withhold cash from the beneficiary if that beneficiary is assigned income via the K-1. I have seen it happen, but mostly it is a timing issue and not an outright denial of proceeds from the estate to pay the taxes.
The key for the reader is to understand that there is a legal binding document that has Articles, Clauses or Sections that explain how income is assigned to the respective owners. In addition there are additional Articles, Clauses or Sections that explain or identify how cash proceeds will be disburse to the respective owners. This is the section of wording in the legal document that the taxpayer must understand to fully grasp their legal rights and obligations related to phantom income.
Methods to Prevent Tax Issues Related to Phantom Income
As a business owner, you want the business operation to be successful. You want income assigned to you. But at the same time, you need the cash to pay the corresponding taxes. Each of the various types of K-1’s (partnership, trust etc.) also identifies how much cash was distributed to the owner. The terms used on the K-1’s include disbursements or distributions depending on the type of business entity.
For the Form 1120-S K-1, it is proclaimed in Block 16 using a letter D and the corresponding dollar amount paid to this shareholder.
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As the owner or one of the owners of the business, you will most likely desire the cash to pay the tax obligation of the assigned incomes. The key is to include this requirement in the legal document binding all partners, shareholders or members. I suggest that the minimum distribution be not less than 35% of the assigned income. In addition, this distribution must be completed prior to March 15 of the following tax calendar year. This provides adequate time for the owner to receive the check, get the check cashed and forward the tax to the respective governing authority.
Be careful with the wording of your legal document. Most well written documents usually bind the business operation to a cash basis reporting format with the Internal Revenue Service, thus the K-1 information is presented to the owner on the cash basis of accounting. This matches the individual’s reporting format with the IRS. If the entity uses the accrual method, there may not be sufficient funds to disburse to the owners for the assigned income. It is rare for these types of entities to operate under the accrual basis. If the legal documents bind the owners to accrual basis of tax reporting, the owners should make sure the company carries adequate cash reserves to fund the disbursement for tax payments.
So far, I have mentioned two tools to ensure tax payments are funded by the business:
- Exercise cash basis tax reporting over accrual
- Require a minimum cash disbursement from the entity funds of not less than 35% paid out prior to March 15 of the following calendar year
A third tool used to alleviate the tax obligation associated with the Phantom Income assigned via the K-1 is utilization of employment compensation. Most small businesses are usually operated by the owners. Therefore, you could fund the tax obligation via additional wages or salary and have a letter of understanding signed by that owner/employee whereby they acknowledge their tax obligation. If in a partnership, you could use guaranteed payments and if in the corporation status, use year-end bonuses. Yes, I understand that they will be taxed for Social Security and Medicare taxes but in accordance with the Internal Revenue Code, it is going to get that tax applied anyway. Active partners in a business must report their income and pay self-employment taxes anyway. For those involved in S-Corporations, any income in excess of reasonable profits will be considered earned income by the IRS and the self-employment tax will be applicable. In most cases, the owners have already exceeded the threshold related to the maximum Social Security Tax base and therefore, only Medicare Taxes are due on the additional assigned wages. The important concept here is that wages are an alternative tool to use to fund the tax obligation. This tool is very effective if the parties have failed to appropriately word the shareholder agreement or the other legal document(s).
There are still a multitude of other tools available to the small business owner. These include exercising Section 179 tax benefits at year-end. You could shift receipts of income into the following year thus reducing the cash income of the entity. This is achievable by communicating with customers to delay their December payments until January. Other options include using cash to reduce payables or even prepay some ongoing monthly liabilities such as rent, utilities etc.
Most importantly, to offset this Phantom Income, talk with your CPA and get their input well before the end of the calendar year. Act on Knowledge.
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