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  2. Phantom Income – Services for Equity Under IRC 83a

Phantom Income – Services for Equity Under IRC 83a

    1. What happens if the business does not distribute any of the profits to the owners?

      A corpora4on or an en4ty being taxed as a corpora4on distributes profits to its shareholders as dividends. If the corpora4on determines that it will not issue a dividend, then the corpora4on pays taxes on the profits at its corporate tax rate and that is all. The money is retained as retained earnings and is available for use in the business. If the business is a pass-through en4ty, there is no taxa4on at the business en4ty level. The share of profits allocable to the equity holder (based upon her share of ownership or based upon any special alloca4on in a partnership) will be reported on her personal income tax statement. If the business retains the profits and does not actually distribute the funds, the equity holder will s4ll have to pay taxes on the funds. This is known as crea4ng “phantom income”, as the equity holder may have to pay taxes on income she did not actually receive.

• Example: Audrey is a 50% owner of an LLC with Eddie. At the end of the year the LLC makes a profit of $10,000. Both par4es determine that it is best to not withdraw any

funds from the LLC and to reinvest the profits in growing the business. The LLC is a pass- through tax en4ty. Both Audrey and Eddie will have to pay taxes on $5,000 at their ordinary individual income tax rates, even though they did not take any money out of the business. Once they pay the taxes on the profit, however, each owner’s basis will be increased by $5,000. This may reduce that tax burden at a later sale of the owner’s equity. Further, they will not have to pay tax again when the profits are actually distributed to them.

• Note: Most startups avoid this issue by reinves4ng all profits into opera4ons during the tax year and not repor4ng a profit in that year.

Another common situa4on giving rise to phantom income arises during the ini4al capitaliza4on of the business. When a member of a business en4ty receives an equity interest in the business in exchange for work or services performed to the business, the individual is taxed on the value of that equity interest at their ordinary individual income tax rates. The amount of tax is based upon the value of the equity interest as measured by the exis4ng assets in the business. The individual receives a valuable asset (equity interest), but doesn’t receive actual cash. Oaen the equity interest received is illiquid, which creates a difficult situa4on for the new equity holder. Nonetheless, the equity holder will pay taxes on the value of equity received with liFle or no ability to liquidate that interest to pay the assessed taxes.

• Example: Eric and Tom form an LLC. Eric invests $1,000 in the business, and Tom provides labor. They divide ownership interest in the business equally. At the end of the year, the business breaks even. Tom will be taxed on the equity interest that he received as a result of his labor. Since the business was worth the value of its assets ($1,000) at the 4me that Tom received an interest in the business, he will be taxed as if he received $500 for his labor.

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