Ghosts, Ghouls, and the Trouble with Phantom Income: The Hidden Dangers of LLCs

In my last article, we discussed the pitfalls of cancellation of debt income and how loans between partners and a business should be reviewed with care. The big takeaway was that cancellation of or reduction in such loans could be viewed as being taxable income to the business. And, in instances where the business is organized as a Limited Liability Company (“LLC”), and elects to be treated as a partnership, partners could find themselves being taxed on income they never actually received.  

The reason for this is that LLCs pass income and losses directly through to the company’s individual partners. There is no taxation at the business level. Say, for example, that an LLC earns $50,000 in annual income, and its partners decide to forego receiving distributions of that income to shore up the company’s cashflow. Such “phantom” income is, nevertheless, applied to the partners as taxable income. The oft-surprising result for partners is that despite their choosing not to receive distributions, the tax authorities still view the income generated by the business as being taxable to them personally.  

By contrast, we have standard, so called, “C” corporations. For these businesses, income that is held for corporate purposes would only be taxable to the corporation, not to its shareholders.  

The prospect that an LLC structure could visit upon its owners phantom income tax liabilities should be considered when pondering the corporate structure to select initially.  

This is why it’s important to consider your corporate structure from the very beginning: You get taxed differently.

When a business needs to spend several years building up capital, investors may not receive payouts for some time. In this case, the LLC structure isn’t the best structure. That’s because while waiting for those payouts, those investors may still have to pay taxes on the income they aren’t seeing personally.

Meanwhile, standard C corporations would pay taxes on a company level, protecting shareholders. Shareholders would only pay taxes on dividends (income distributions) received by them or income generated via the sale of their shares. 

It’s also good to consider if the business intends to ramp up based on attracting capital from third party investors, or if it ultimately intends to be sold to a Venture Capital firm. In either case, establishing the company as a standard C corporation may be the better choice. Third party investors are unlikely to want to be exposed to potential tax bills associated with phantom income. They would rather hold shares in an enterprise and pay taxes on them only when the shares are sold.  

Additionally, Venture Capital firms (“VCs”) may be restricted from being able to invest in LLCs because of stockholder rules. For example, VCs that invest on behalf of tax-exempt partners may be precluded from investing in pass-through entities, like LLCs, since passing through commercial revenues to a tax-exempt partner could jeopardize that partner’s tax-exempt status. LLCs generating income in multiple states, potentially complicating a partner’s tax obligations, could deter potential investors.  

Are LLC’s ever the right choice? Yes, if you start making money right away.

A business that is likely to turn a profit quickly is more likely to benefit investors if it employs an LLC structure. This is  because double taxation, first at the business level,  and then at the investor level, would be avoided. 

In sum, while the LLC is a popular corporate structure that is relatively easy to set up and maintain, it is not always the best corporate structure depending on how the business operates and its objectives. As with all things legal, entrepreneurs should consult with an attorney before choosing a corporate form for their business. Selecting the wrong corporate form could end up discouraging potential investors as well as imposing unexpected tax burdens on existing investors.  

 Related Articles:

Cancellation of Debt Income Is a Trap for the Unwary

Here’s How Remote Workers Will Impact Your Taxes

The S-Corp or the New LLC?

Consider the Flexibility of an LLC