Phantom Income

gettyimages_108909037-resized-600.jpgIt comes as a surprise to some clients who are involved in a partnership or S-Corporation that they owe money on April 15th. The clients did not receive any cash from the partnership so they believe no tax is due. This is a common misconception as a lot of business owners believe they only get taxed on their distributions. Instead of educating the clients some accountants explain it away as phantom income.

What occurs is the partnership or S-Corporation has received cash or earned the revenue and is reporting the partner’s share of that income. A cash flow statement is a helpful tool but not what the income taxes are based on. Instead the tax liability is based on the business’ profit and loss statement. Business purchases can often be capitalized and deducted in the year sold to customers instead of the year the inventory is purchased.  Some assets are also depreciated over the life of the asset instead of the year the asset was purchased. These timing delays can create additional confusion for shareholders. 

Below is an example of one situation that can be problematic.

The client has $100,000 of profit sitting in the bank account. Instead of issuing any distributions to the partners, they have decided to reinvest the funds back into the company. They use up their cash reserve hiring a contractor to remodel their store front. While the remodel used up their cash, the asset they have placed into service is depreciated over 15 years.  Instead of a $100k expense that would offset the income for the year, they only have depreciation expense of roughly $6,666.67 per year for 15 years. 

This is problematic is because of the income being reported on the K-1 is roughly $93.3k (100k profit less the 6,666 deduction). Even with the company not distributing cash to the partners, they will have to pay taxes on this 93k. For this example we will use an effective tax rate of 20% for the partner. The partner will owe about 18k in taxes. At this point the business might not have cash to provide to the owners to pay their tax liability.

It is always advisable to consult with your tax advisor prior to making any decisions that could impact your taxes.  To prevent this issue, many partnerships will distribute cash quarterly at the highest tax rate.

For  more information or if you have questions regarding this, please contact Kylan McNemar.

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