Before you invest in any business or real estate as an investor or before you partner with anyone, make sure you have a clear agreement regarding phantom income.
If you don’t handle this upfront, you could find your tax return haunted by this expensive phantom.
Does Your Business Have a Phantom?
All business structures are flow-through entities, with the exception of the C Corporation. If you are an owner in one of the flow-through entities such as S Corporations or Partnerships (or LLCs taxed as one of these), you will receive a K-1 at the end of the tax year reporting your percentage of the income to report on your personal tax return.
Now, here’s the problem. If your agreement doesn’t have a clause for phantom income, you may find that you have to report a portion of the income as taxable, but never receive any distributions. In fact, if you ever have a falling out with your partners or fellow shareholders and they take over control, you could find the K-1 becomes an excellent tool in a squeeze play. You could keep receiving K-1s, year after year, without any cash to go along with it. That’s phantom income! Eventually the phantom income will likely get the better of you. And that’s what the other party is counting on.
Protect yourself by making sure there is a phantom income clause in every agreement you have that guarantees that a certain percentage of the K-1 income will always, at a minimum, be distributed. For example, I like to use 30% in my agreements.