Strategies for Tax Distributions to Cover Phantom Income

Phantom income refers to the income on which you must pay tax, although you have not earned it in actual dollars. It is one of the most frequent and unexpected surprises for the LLC and S-corp partners and the fixed-income investors who face similar tax consequences.

Since pass-through organizations do not pay dividends out of their earnings but keep them in their accounts to finance themselves, such profits are distributed among the partners as income even when they have not seen a single penny from these profits.

Why Phantom Income Creates A Liquidity Problem

The main problem is the disparity between cash flow and income tax. The profits of a partnership may amount to $200,000, yet a partner will be required to pay over $80,000 in income taxes without receiving any cash.

In order to satisfy these tax obligations, a partner will have to withdraw money from their own account or dispose of some assets. That is precisely the reason why tax distribution techniques are crucial and should form part of the overall strategy from the outset.

Phantom Income Strategies

Strategy 1: Include a Tax Distribution Clause

The most efficient instrument would be inserting a provision in the LLC Operating Agreement or Partnership Agreement concerning tax distribution. It will obligate the business entity to distribute money among its members in order to enable them to pay taxes based on the distributed income.

Read to know more about Taxation in Phantom Stock Plans

A generally accepted standard involves distributing between 30% and 40% of the taxable income to ensure that there is enough money for paying taxes. Under the aforementioned principle, if the company makes a profit of $200,000, and the partner owns 20% of it, they will receive $14,800 for tax distribution purposes.

Strategy 2: Quarterly Estimated Tax Payment

Whereas there may be no safety net in case the taxpayer fails to use the distribution clause, quarterly estimated taxes will come in handy for those business owners. The IRS wants you to either pay 90% of the tax liability of the current year or 100% of the previous year’s (or 110%, for people with adjusted gross incomes of more than $150,000).

This is where midyear reviews of the tax are crucial. Any change in your phantom income will mean that you have to make adjustments to your quarterly estimates.

Strategy 3: Tax-Loss Harvesting

Tax-loss harvesting is one of the most actionable strategies for investors with phantom income from securities. The approach involves selling underperforming investments to realize a capital loss, which then offsets phantom gains elsewhere in the portfolio.

The deadline for realizing any losses is December 31 for them to qualify as deductions during the same tax year. Any additional losses that exceed the amount of gains within the tax year can be used as deductions in future years.

Strategy 4: Use Tax-advantaged Accounts

Investment in phantom income-producing investments, such as zero coupon bonds, TIPS, or actively traded mutual funds, when placed in tax-favored accounts, such as a Traditional IRA, Roth IRA, or 401(k), results in no taxation in the current year or even ever.

As far as equity compensation goes, the Roth IRA becomes especially useful because all gains occur without taxation.

Strategy 5: Asset Location & Charitable Strategies

Strategic asset location involves holding phantom income assets in tax-deferred accounts and tax-efficient assets in taxable accounts. High-net-worth individuals can benefit from additional charitable giving techniques such as Donor Advised Funds (DAF) or Qualified Charitable Distributions (QCD).

Operating Agreement Review Checklist

Before your next tax year starts, take a look at the following aspects of your entity’s operating agreement:

• Tax distribution rate – Is 30-40% of income allocation sufficient for taxes?
• Timing of distributions – Do they match up with IRS quarterly payments?
• Income allocation method – Is it done based on units, contributions, or originations?
• Cost basis tracking – Have the equity compensation and asset sales been evaluated for any phantom gains?
• Withholding policy – Do they have an ongoing reserve (25%) from distributions?

Distribute Smartly, and Avoid Costly Surprises with Eqvista

Phantom income need not be a problem. Using the proper balance of a tax distribution clause, responsible estimated payments, strategic loss utilization, and shrewd account setup, any company can offset its phantom income and eliminate any potential problems before they happen.

The first and easiest step in preventing phantom income is building the solution into the operating agreement prior to allocation. Once this framework is in place, tax distributions are seamless, ensuring each and every partner is protected, quarter after quarter, and year after year.

With Eqvista, founders and startups can monitor equity distribution, plan for income, and avoid phantom income issues – all on one platform created specifically for equity management teams.