Phantom income is an accounting term given to income generated by the LLC (limited liability company) or LP (limited partnership) that hasn’t been distributed to the members. It’s called “phantom” income because it exists on paper. It’s taxable income and you pay tax on it, even though there is no cash that comes to you.
We see phantom income arise in cases where the LLC or LP needs operating capital to expand or to keep as a cash reserve. On paper the LLC may have $80,000 in distributable profit, but it needs to hang onto $40,000 for an equipment purchase. Yet as an owner, you’re going to see your full share of that $80,000 reported on your partnership Schedule K-1, even if the LLC isn’t going to cut you a check for that amount.
It can also become an issue in a partnership argument. If Partner A controls the purse strings, he may choose to withhold distributions to force Partner B to an agreement. Otherwise, Partner B gets taxable income on a Schedule K-1 from the partnership return but no cash so he can pay the tax.
As you can imagine, phantom income can happen pretty easily in just about any type of business. Given the nature of flow-through taxation there isn’t much you can do to avoid it unless you’re a manger in the company or otherwise have some kind of control, but there are ways you can minimize its impact on your personal tax situation.
The traditional (and most often-used) method is to make sure your Partnership or LLC Operating Agreement has a mandatory distribution requirement that will cover the tax payable on a phantom income distribution. That’s one more reason to make sure you have an expert helping you set up your business structure.