OVERVIEW
Given how important the issue of phantom income is to anyone who owns shares in a corporation (or a membership interest in an LLC), one would expect most business owners to at least be familiar with the concept. Surprisingly, that isn’t the case. In fact, the vast majority of my business/corporate clients—including owners of multi-million dollar companies—have little to no understanding of what phantom income is or how it could effect them.
While phantom income often arises within the context of ordinary business operations (e.g., a company’s use of non-cash compensation, such a company car, or acquiring another company’s stock upon the sale of a business) with no intentional motives, that is not always the case. Majority shareholders (or controlling members of an LLC) can, for example, use the concept of phantom income as a sword against minority owners. And despite the fact that such practices are absolutely legal, there are things that investors thinking of buying into a business can do to protect themselves from such practices being used against them in the future.
WHAT IS PHANTOM INCOME?
Phantom income refers to income that is taxable to a shareholder (or in the case of an LLC, a member) even where: (i) such income is never actually received by the shareholder; or (ii) is “paid” in some form other than cash or property. In other words, phantom income is taxable income that must be reported on an individual’s tax return even though it is not actually received in a tangible form.
EXAMPLES OF PHANTOM INCOME?
Phantom income can arise in a variety of circumstances, such as:
- Stock Options. When a company grants stock options to an employee, the employee has the right to purchase a certain number of shares of the company’s stock at a fixed price. If the stock price rises above the option price, the employee can sell the stock and realize a profit. The difference between the option price and the stock price at the time of sale is considered taxable income, even if the employee has not actually received any cash yet.
- Non-Cash Compensation. Some companies offer non-cash compensation, such as a company car or other non-cash perks. The value of those benefits is considered taxable income even though the employee has not received any physical cash. This can result in a larger tax bill for the employee, as the value of these benefits will be added to the employee’s taxable income.
- Sale of a Business. When a business owner sells their business, they may receive stock in the acquiring company or other forms of compensation that are not in the form of physical cash. This income is still considered taxable, even though the business owner has not received any physical cash.
- Withholding Distributions (S-corporations or LLCs). Unless an S-corporation or LLC’s governing documents (e.g., shareholder or operating agreement) specify otherwise, California law’s default position is that the company is not required to make regular distributions to its shareholders/members. As long as the company isn’t being wound up or sold, the board of directors (or managing members in the case of an LLC) can choose to sit on net revenues and keep the money in the company’s bank accounts forever. The problem is that most S-corporations and LLCs are taxed as partnerships—where the profits and losses of the companies are passed through to the owners’ personal tax returns. For example, assume that you have a 25% membership interest in an LLC. And assume that your company has $100,000 in net revenues for the year. If your LLC were distributing the net revenues to the members, you’d be entitled to receive 25% of those revenues, or $25,000. But if your LLC does not actually make a distribution this year, you’re going to still receive a K-1 imputing that $25,000 to you, and you’re going to have pay taxes for that $25,000 as if you’d received the money. That is phantom income.
PHANTOM INCOME CAN BE USED AS A WEAPON AGAINST MINORITY SHAREHOLDERS
Take another look at the last type of phantom income discussed above—withholding distributions. Majority shareholders/managing members have been able to weaponize the concept of phantom income by withholding distributions to the shareholders/members. And it’s perfectly legal.
Let’s return to the example from above. You own a 25% membership interest in an LLC with net revenues of $100,000. If the individuals in charge of your company decide to withhold distributions (including from themselves, you’re going to be responsible for taxes incurred on your $25,000 even though you didn’t actually receive the money (because the company kept it in the corporate bank account). You can see how that could become a problem.
Yes, such an exercise requires the majority shareholders/managing members to deny themselves distributions as well. And yes, those same individuals will be in the same phantom income boat that you’re in. But what if they can afford it easier than you can? What if you are silent investor (i.e., you have a day job and don’t work for the company) and they are officers who receive a salary? Or what if they have other forms of income and you are relying on expected distributions to maintain your lifestyle?
You can see how, at least in those cases, the concept of phantom income could be used as a weapon. Unfortunately, once a shareholder/member is stuck in that situation, there’s little they can do (absent convincing the other shareholders/members to stop the practice) because the practice is absolutely legal.
But there is something one can do if they’re aware of phantom income before they become an investor in a corporation or LLC.
THERE ARE WAYS TO REDUCE THE THREAT OF PHANTOM INCOME BEING USED AS A WEAPON
When I introduced the issue of withholding distributions above, I began by stating the default position under California law. A company’s governing documents, however, can alter the law’s default position.
When I’m forming an S-corporation or LLC for a client, I always pose two critical questions to them. First, I ask them if they want to include a provision that, absent a super-majority (or unanimous) vote to the contrary, requires them to distribute a certain percentage of the company’s net profits to the shareholders/members each year. If they answer “yes,” I then ask them what percentage they’d like to require. If they answer “no,” I ask them whether or not they at least want to require the company to advance to each shareholder/member a sum equal to the anticipated taxes that each shareholder/member will owe on the withheld distribution. That way, even if the shareholders/members don’t receive their distributions, the company will advance the amount that the shareholder/member will have to pay in taxes. Then, once distributions are made in the future (even upon an eventual sale of the company), the advances will be deducted from the earned distributions before each shareholder/member is paid out.
Of course, when I’m representing an individual who is considering investing in an existing company, I look at the target company’s governing documents to determine whether such protections exist. When they don’t, I discuss the potential abuses relating to phantom income with my client. From that point, my client and I can decide how to best proceed.
CONCLUDING THOUGHTS
The concept of phantom income, while not very well known, is an extremely important one to understand. In my experience, it’s most often used as weapon against minority shareholders/non-managing LLC members in the form of withholding distributions. And while there isn’t much one can do after-the-fact, if you’re aware of the issue before you invest, you can take steps to protect yourself.