With the end of the taxable year upon us, many shareholders or members of closely-held corporations or limited liability companies are anticipating the receipt of their K-1s for 2023. Today we wanted to take a moment to talk about a recurring theme we see in disputes between partners and shareholders: "phantom income." For this article we called upon Mark Corrado, CPA of Corrado Financial Group in Ramsey, New Jersey, to contribute his thoughts on this thorny issue.
"Phantom income" has been described in the context of a subchapter S corporation as "the liability that shareholders in an S corporation face for taxes on their share of the corporation's profits, even if those profits are not distributed to the shareholders as dividends."1 This same problem can arise in the context of an LLC where the entity is taxed as a partnership.
For illustration, assume this scenario:
- You own a minority (20%) interest in an LLC, and the LLC Operating Agreement does not require the majority members to make regular distributions or to distribute out net profits each year;
- Your LLC has $250,000 in net revenues for the year, and you receive a K-1 imputing 20% ($50,000) of that income to you, obligating you to report that income on your personal returns;
- The majority members (those in control) decide to keep the profits in the LLC and to not distribute the profits out to the members. While they will also be paying taxes on income they have not actually received, they may be in a better financial position to do so and, more importantly, expect that this financial pressure on the minority members could bring them a long way toward achieving their long-term goal of squeezing them out.
This is a classic example of how phantom income could be weaponized to oppress a minority shareholder/member. When these acts by the majority are coupled with other acts of oppression, it could be a basis for a lawsuit claiming oppression by the majority.
According to Mark Corrado, CPA, of Corrado Financial Group, "it is not uncommon to have a client consult us in a situation where they have been saddled with phantom income. It is often the case that this occurs because those in control of the corporation or LLC are looking to make life difficult for the minority shareholder or member. It is certainly important for one investing in a closely-held business to consult with a knowledgeable attorney or accountant before making the investment so that the client understands this potential pitfall and how to avoid it."
In our prior articles we have talked about the remedies available to a shareholder or LLC member for oppression by the majority, and the risks to the majority of certain conduct that could be viewed as oppressive. If a shareholder or member finds themselves in this situation, and assuming those in control have followed the letter of your shareholders' agreement or operating agreement, there may be little that can be done, in the absence of other acts of oppression.
Armed with the knowledge of this potential risk, those who are negotiating new agreements can take action now to head this practice off at the pass. We can help to negotiate up front provisions to help protect you down the road, such as provisions requiring a company or LLC to distribute a certain percentage of net profits each year, or at a minimum a provision requiring the company to advance to each shareholder/member a sum equal to the anticipated taxes that each will owe on the withheld distribution.
1. A.W. Chesterton Co. v. Chesterton, 128 F.3d 1, 3 n.1 (1st Cir. 1997).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.