What happens if the business does not distribute any of the profits to the owners?
A corporation, or an entity being taxed as a corporation, distributes profits to its shareholders as dividends. If the corporation determines that it will not issue a dividend, then the corporation 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 entity, there is no taxation at the business entity level. The share of profits allocable to the equity holder (based upon her share of ownership or based upon any special allocation 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 still have to pay taxes on the funds. This is known as creating “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 parties 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 entity. 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 reinvesting all profits into operations during the tax year and not reporting a profit in that year.
Another common situation giving rise to phantom income arises during the initial capitalization of the business. When a member of a business entity 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 existing assets in the business. The individual receives a valuable asset (equity interest) but doesn’t receive actual cash. Often, the equity interest received is illiquid, which creates a difficult situation for the new equity holder. Nonetheless, the equity holder will pay taxes on the value of equity received with little 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 time that Tom received an interest in the business, he will be taxed as if he received $500 for his labor.