FIVE COMMON EXAMPLES OF PHANTOM INCOME IN BUSINESS TRANSACTIONS

A person has phantom income when she or he has taxable income, but does not receive an equal amount of cash. Phantom income is generally dreaded by taxpayers and tax advisers alike. Yet, it occurs surprisingly frequently in many common business transactions. In many cases, if planned for, phantom income may be prevented or otherwise dealt with.

Below are five common instances:

• Selling property for equity interests. While it is certainly appealing and seems reasonable to expect that the receipt of equity interests in corporations or partnerships[1] in exchange for property would be tax-free, it is often not. Property-for-share exchanges, share-for-share exchanges, and stock mergers are tax-free only if enumerated requirements of Section 368 or 351 of Code[2] are met. The intricate requirements of each type of tax-free corporate transaction are not discussed here in detail. However, some of the key requirements relate to whether the stock received in the exchange is voting or nonvoting, how much of the stock of the acquiring corporation is owned by the selling shareholders after the transaction, whether the target corporation made significant distributions before the transaction, whether the target corporation survives as an entity, and whether the liabilities of target corporation exceed certain thresholds. The specific requirements vary depending on the particular form the exchange takes. Property exchanges for LLC or limited partnership (LP) interests are likewise taxable unless certain requirements are met. Some of the most commonly overlooked reasons that tax may be triggered include that the property being exchanged is subject to debt or debt is otherwise also being transferred to the LLC or LP; that distributions are received relatively close in time to the property exchange; and that the LLC or LP interests are received not solely for property, but for some type of service as well.

• Selling property for deferred consideration. Sellers tend to assume that if they are receiving a portion of the purchase price in a year after the closing, they will not have to report all their taxable gain in the tax year of the sale, and can instead space it out as they receive the deferred purchase price. However, the use of the installment method to report gain is available only if various prerequisites are met. Further, the use of the installment method to report taxable gain requires the payment of a nondeductible interest charge to the government on the deferred tax where the amount of the note exceeds a certain threshold. In addition, transfers of the notes or rights to the deferred purchase price (whether the transfers are to related parties or for full consideration) can accelerate any deferred taxable gain.

• Selling property for debt that does not regularly pay adequate interest. Unless the debt received pays interest at least annually, and the interest payable is at a rate at least equal to a rate published by the IRS (the applicable federal rate), the holder of the debt has phantom interest income. This happens where the debt provides for no interest or insufficient interest. It also may arise where the note provides for contingent interest payments–for example where payments on a note (including that of interest) are dependent on certain earning levels being reached.

• Structuring equity incentives for employees. Inadequate attention to the tax consequences of various types of equity compensation can result in unwelcome surprises for the recipients. In particular, in the context of equity interests in partnerships (including LLCs treated as partnerships for tax purposes), a lack of understanding as to what a profits interest is, as well as how to draft for the issuance of a profits interest, may result in the issuance of a taxable interest  as opposed to a profits interest. See our previous advisory regarding the drafting of profits interests in partnerships. Phantom income may also arise upon an exercise of both nonqualifed and qualified employee stock options.

• Inadequate or insufficient tax distributions for members/partners of LLCs or LPs. Partners/members of partnerships and LLCs can have taxable income allocated to them, whether or not the partnership or LLC makes any distributions to them. Many-business people tend to assume that the tax allocations of income will “follow” cash distributions. However, (i) the amount of taxable income is often different than the amount of cash a partnership has, (ii) there are many different methods for drafting allocation provisions in partnership agreements (including “targeted allocation” provisions), and only careful analysis can confirm that the allocations will be done in a manner that is in line with the expectations of the members.

• Many operating agreements require distributions to the members/partners in amounts approximating their tax liability resulting from income allocations made to them. Tax distributions may not be drafted in such a manner as to cover the actual tax liability of each member/partner. See our previous advisory regarding considerations that should be taken into account in ensuring tax provisions are drafted correctly.

Sellers would be well-served to engage in an analysis of the timing of taxable income to them. As stated above, in many cases, if planned for, phantom income may be prevented or otherwise dealt with.

[1] Domestic limited liability companies (“LLCs”) with more than one member are treated as partnerships for U.S. federal income tax purposes unless they have elected to be treated otherwise. When referring to LLCs, this advisory assumes that such LLCs have not elected to be treated as other than partnerships for U.S. federal income tax purposes.

[2] Sections are to references of the U.S. Internal Revenue Code of 1986, as amended (the “Code”).