No check arrived, no cash was deposited into your account, yet a tax bill shows up for your pass through entity. Why? Because the IRS taxes you based on your share of the entity’s income, not on what was actually paid out to you. Here’s what you should know about “phantom income”.

Quick Takeaways

• Pass-through entities report income on a Schedule K-1, even if no cash is distributed.
• You may owe taxes on income you never received, called “phantom income.”
• Understanding your entity’s distribution policy and planning ahead can help minimize the impact.
• Tax distributions and good recordkeeping are essential to managing the tax burden.

What is a pass-through entity?

A pass-through entity is a business structure that reduces the effects of double taxation, (which occurs when income tax is levied once on corporate income, then again when profits are distributed as dividends to shareholders). Income or loss from a pass-through entity flows through to the individual owners and is taxed only once on the owners’ individual tax returns. Therefore, these types of entities are not subject to income tax at the entity level.

Common pass through entities include partnerships, S corporations, and Limited Liability Companies (LLCs). These entities report profits and losses on IRS Schedule K-1, which gets distributed to each owner or member for inclusion on their personal tax returns.

Why sometimes you pay tax on income you did not receive

The key thing to keep in mind here is that how income is reported is different than how cash is distributed. Even if no distributions were made to you, your K-1 reflects your share of the entity’s taxable income. 

This is often referred to as “phantom income,” i.e. taxable income reported on paper but not actually received in cash. 

Here’s how this can happen:

• Reinvestment- Your entity could choose to retain profits to reinvest in the business rather than distributing to partners or shareholders.
• Debt repayment or reserves- Cash can be used to pay down debt or held as reserves. In this case, there would be no cash available to distribute.
• Uneven distributions- In certain circumstances distributions can be made to certain partners but not others. It depends on the partnership agreement. 

What can you do to mitigate the impact of phantom income?

Phantom income can be frustrating, but there are ways to minimize the sting. Here are a few strategies to consider:

1. Review the Operating or Partnership Agreement- Make sure you understand how and when distributions are made. If you’re considering joining a pass-through entity, ask whether it has a policy to distribute enough cash to cover the taxes owed on allocated income.
2. Ask About Tax Distributions- Many well-managed entities issue tax distributions (payments to help cover the tax liability on K-1 income). If your business doesn’t offer them, consider raising the issue with fellow partners or managers.
3. Plan Ahead for the Tax Bill- If you know you’re likely to receive phantom income, build it into your estimated tax payments or set aside funds during the year.
4. Track Basis and Distributions- It’s critical to keep accurate records of your basis in the entity, which can affect the taxation of distributions, losses, and gains when you exit the business.
5. Consider the Entity Structure- If phantom income is a recurring problem, it might be worth reconsidering whether a pass-through entity is the right structure for your investment or business goals.

FAQs- K-1 Income and Phantom Taxation

1. What is phantom income?
   Phantom income is taxable income you must report, even though you didn’t receive any cash from the business.
2. How can I avoid paying tax on phantom income?
   You can't avoid the tax, but you can plan ahead by negotiating tax distributions and setting aside funds in advance.
3. Do all K-1s result in phantom income?
   Not always. Some entities distribute cash in line with reported income. It depends on how the business is structured and managed.
4. What happens if I don’t have cash to pay the tax?
   You may face penalties or interest if you can’t pay on time. Planning ahead and requesting tax distributions can help avoid this.