Phantom Income in an LLC: Taxed on Cash You Never Got

Why Are You Taxed on LLC Profits You Never Received?

You are taxed on LLC profits you never received because federal law taxes a partnership’s income to its partners, not to the partnership. Each member reports a share of the profit set mainly by the operating agreement, and that share is taxable whether the company distributes it or keeps it.

Under 26 C.F.R. § 301.7701-3(b)(1), unless it elects otherwise, a domestic LLC is “A partnership if it has two or more members.” 26 U.S.C. § 701 then provides: “Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” Under 26 U.S.C. § 702(a), “In determining his income tax, each partner shall take into account separately his distributive share of the partnership’s” income, gains, losses, and other items. 26 U.S.C. § 704(a) adds: “A partner’s distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this chapter, be determined by the partnership agreement.”

In practice, the Schedule K-1 you receive reports your allocation, not your cash. A profitable year with no distribution leaves you with a tax bill and nothing from the company to pay it. I suggest asking your CPA to compare the K-1 allocation with the operating agreement, because § 704(a) ties the allocation to that agreement. For Minnesota income tax, a qualifying LLC or S corporation “may elect to file a return and pay the pass-through entity tax” under Minn. Stat. § 289A.08, subd. 7a, an election that “may only be made by qualifying owners who collectively hold more than 50 percent of the ownership interests in the qualifying entity held by qualifying owners.” When it does, an owner’s liability to pay estimated tax on that amount “is, however, satisfied when the qualifying entity pays estimated tax,” and the subdivision “expires for taxable years beginning after December 31, 2027.”

How Does Phantom Income Work for an S Corporation Shareholder?

An S corporation shareholder faces the same mismatch: the corporation’s income passes through to the shareholders by ownership share, and each shareholder owes tax on that share whether or not the board pays a distribution. The one-class-of-stock rule for S status looks for governing provisions that give every share identical distribution rights, and under 26 C.F.R. § 1.1361-1(l)(2), distributions “that differ in timing or amount are to be given appropriate tax effect in accordance with the facts and circumstances.”

26 U.S.C. § 1366(a)(1) provides that, in figuring a shareholder’s tax, “there shall be taken into account the shareholder’s pro rata share of the corporation’s” income, loss, deduction, and credit items. Under 26 U.S.C. § 1361(b)(1)(D), an S corporation may not “have more than 1 class of stock.” Under 26 C.F.R. § 1.1361-1(l), “a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.” That test looks at the charter, bylaws, state law, and “binding agreements relating to distribution and liquidation proceeds.”

For you, that means a tax distribution in an S corporation should go to every shareholder by ownership percentage, because the governing documents must confer identical distribution rights. For a distribution “by an S corporation which has no accumulated earnings and profits,” 26 U.S.C. § 1368(b)(1) provides: “The distribution shall not be included in gross income to the extent that it does not exceed the adjusted basis of the stock.” Your CPA tracks that basis. My page on tax issues for minority shareholders covers other shareholder tax questions.

What Does Minnesota Law Say About Your Right to a Distribution?

Minnesota law gives an LLC member no right to a distribution before the company dissolves unless the company decides to make one, and the operating agreement can change that default. When a Minnesota LLC does distribute, Minn. Stat. § 322C.0404, subd. 1, sets the default split “in equal shares among members and dissociated members, except to the extent necessary to comply with any transfer effective under section 322C.0502 and any charging order in effect under section 322C.0503.”

Minn. Stat. § 322C.0404, subd. 2 provides: “A person has a right to a distribution before the dissolution and winding up of a limited liability company only if the company decides to make an interim distribution.” For an LLC formed before August 1, 2015, Minn. Stat. § 322C.1204, subd. 3 instead provides, subject to the operating agreement, that distributions “must be allocated in proportion to the value of the contributions of the members reflected in the records” the company must keep.

Under Minn. Stat. § 322C.0110, subd. 1, “Except as otherwise provided in subdivisions 2 and 3, the operating agreement governs” relations among the members, and subdivision 2 provides: “To the extent the operating agreement does not otherwise provide for a matter described in subdivision 1, this chapter governs the matter.” Subdivision 3 lists terms an operating agreement may not include, among them terms that “unreasonably restrict the duties and rights stated in section 322C.0410” or that vary a court’s power to decree dissolution in the cases covered below. Under Minn. Stat. § 322C.0405, subd. 1, a limited liability company “may not make a distribution if after the distribution” either “the company would not be able to pay its debts as they become due in the ordinary course of the company’s activities” or its total assets would be less than its total liabilities plus certain members’ preferential rights on dissolution.

A corporation’s distributions run through its board, under a solvency condition and any rights the articles, bylaws, or an agreement set. Under Minn. Stat. § 302A.551, subd. 1, “The board may authorize and cause the corporation to make a distribution only if the board determines, in accordance with subdivision 2, that the corporation will be able to pay its debts in the ordinary course of business after making the distribution,” and “the rights and priorities of persons to receive distributions may be established by, the articles or bylaws or an agreement.” My page on Minnesota operating agreement defaults covers the other gaps the statute fills.

What Should a Tax Distribution Clause Require?

A tax distribution clause should require the company to pay each owner enough cash to cover the tax on that owner’s allocated profit. It should also set a formula and a schedule and yield to Minnesota’s solvency limits. Distribution rights like these can come from an LLC’s operating agreement or, in a corporation, from “the articles or bylaws or an agreement” under § 302A.551, subd. 1, and Minnesota courts have enforced a written promise to distribute.

Minn. Stat. § 322C.0110, subd. 1 makes the operating agreement govern “relations among the members as members and between the members and the limited liability company,” and § 302A.551, subd. 1, lets the articles, bylaws, or an agreement set shareholders’ rights to distributions. In Drewitz v. Motorwerks, Inc., 867 N.W.2d 197 (Minn. App. 2015), a 30% shareholder of a Minnesota corporation had a signed shareholder agreement, and “The shareholder agreement provided that distributions would be paid to all shareholders on a pro rata basis.” Quoting its own earlier decision in the case, the Court of Appeals said Motorwerks breached its promise “to make distributions to Drewitz while he was a shareholder.” The district court then “entered judgment against Motorwerks for $7.9 million,” a figure that included preverdict interest.

A clause that protects a minority owner should cover these points:

1. Mandatory or discretionary. The clause should say the company must make the payment, because § 322C.0404, subd. 2, gives no right until the company decides to distribute.
2. Formula. The clause should multiply each owner’s allocated taxable income by an assumed tax rate the agreement names, because the K-1 allocation, not the cash, sets the tax.
3. Timing. Payments should arrive before owners’ estimated tax payments are due, a schedule your CPA can set.
4. Credit against later distributions. The clause should say whether a tax distribution is an advance against the owner’s later distributions, so no one argues about it at a sale or buyout.
5. Pro rata for S corporations. In an S corporation, the clause should pay every shareholder by ownership percentage, because of the identical-rights rule in the Treasury regulation.
6. Solvency carve-out. The clause should yield to § 322C.0405 or § 302A.551, because the company may not make a distribution those sections bar.

In an LLC, a member who becomes entitled to a distribution also gains a creditor’s status for it. Under Minn. Stat. § 322C.0404, subd. 4, “If a member or transferee becomes entitled to receive a distribution, the member or transferee has the status of, and is entitled to all remedies available to, a creditor of the limited liability company with respect to the distribution.”

When Does Withholding Distributions Become an Owner Dispute Under Minnesota Law?

Withholding distributions can become a legal dispute in Minnesota when it breaches an agreement among the owners. It can also be part of conduct a court could find oppressive in an LLC or unfairly prejudicial in a corporation, among other grounds. An LLC’s operating agreement may be “oral, in a record, implied, or in any combination thereof” under Minn. Stat. § 322C.0102, subd. 17. Under § 322C.0404, subd. 2, an LLC member has a right to a distribution before dissolution and winding up “only if the company decides to make an interim distribution.” The questions are therefore what you were reasonably promised and what else those in control are doing.

For an LLC, Minn. Stat. § 322C.0701, subd. 1 lets a member apply for a court order dissolving the company when the managers, governors, or members in control “have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant.” Subdivision 2 provides: “In a proceeding brought under subdivision 1, clause (5), the court may order a remedy other than dissolution, which may include the sale for fair value of all membership interests a member owns in a limited liability company to the limited liability company or one or more of the other members.” Under Minn. Stat. § 322C.0110, subd. 3, an operating agreement may not “vary the power of a court to decree dissolution in the circumstances specified in section 322C.0701, subdivision 1, clauses (4) and (5).” Under subdivision 3 of § 322C.0701, an application “must be brought in a court within the county in which the registered office of the limited liability company is located.”

Minn. Stat. § 322C.0102, subd. 18 defines oppressive conduct as conduct “that is unfairly prejudicial to the applicant member in a capacity listed in clause (2), because the conduct frustrated an expectation of the applicant member” that meets four tests. The expectation must be reasonable in light of the other members’ reasonable expectations. It must be one that “was material to the applicant’s decision to become a member of the limited liability company or for a substantial time has been material during the member’s continuing membership.” The other members must have known of it or had reason to know. Section 322C.0102 also requires an expectation that “is not contrary to the operating agreement as applied consistently with the contractual obligation of good faith and fair dealing” under Minn. Stat. § 322C.0409, subd. 4, which requires a member to act “in a manner, in light of the operating agreement, that is honest, fair, and reasonable.” Under § 322C.0102, conduct “includes words, action, inaction, and any combination of words, action, or inaction,” but it “is not oppressive solely by reason of a good faith disagreement as to the content, interpretation, or application of the company’s operating agreement.” In a manager-managed LLC, § 322C.0409, subd. 7, provides that “A member does not have any fiduciary duty to the company or to any other member solely by reason of being a member,” and § 322C.0102, subdivision 18, looks to the conduct of managers in a manager-managed LLC, governors in a board-managed LLC, and members in control.

For a corporation, Minn. Stat. § 302A.751, subd. 1 allows relief when “the directors or those in control of the corporation have acted in a manner unfairly prejudicial toward one or more shareholders in their capacities as shareholders or directors of a corporation that is not a publicly held corporation, or as officers or employees of a closely held corporation.” Under subdivision 3a, the court considers “the duty which all shareholders in a closely held corporation owe one another to act in an honest, fair, and reasonable manner in the operation of the corporation” and “the reasonable expectations of all shareholders as they exist at the inception and develop during the course of the shareholders’ relationship with the corporation and with each other,” and written agreements “are presumed to reflect the parties’ reasonable expectations concerning matters dealt with in the agreements.” Under subdivision 3, the court “shall not refuse to order equitable relief, dissolution, or a buy-out solely on the ground that the corporation has accumulated or current operating profits.” If the court orders a buyout, subdivision 2 sets the price at fair value “as of the date of the commencement of the action or as of another date found equitable by the court.” When the shares are subject to sale and purchase under “the bylaws of the corporation, a shareholder control agreement, the terms of the shares, or otherwise,” however, the court orders the sale on those terms “unless the court determines that the price or terms are unreasonable under all the circumstances of the case.”

Under both statutes, the facts that bear on your expectation include any written promise of tax distributions, a practice of paying them that stopped, and what the other owners told you when you invested. My pages on shareholder oppression and on whether a majority can force a member out of a Minnesota LLC cover the related claims.

How Do You Get the Numbers Behind Your K-1?

You get the numbers behind your K-1 by demanding the company’s financial records in writing under the Minnesota records statute that fits your company. Federal law separately requires a partnership to give each partner the return information that becomes the K-1.

26 U.S.C. § 6031(b) requires “Each partnership required to file a return under subsection (a)” to furnish each partner “a copy of such information required to be shown on such return as may be required by regulations.” For more than the K-1, Minnesota’s records statutes apply:

• Member-managed LLC. Under Minn. Stat. § 322C.0410, subd. 1, “On reasonable notice, a member may inspect and copy during regular business hours, at a reasonable location specified by the company, any record maintained by the company regarding the company’s activities, financial condition, and other circumstances, to the extent the information is material to the member’s rights and duties under the operating agreement or this chapter.”
• Manager-managed or board-managed LLC. Under subdivision 2, you may obtain information “as is just and reasonable” if your purpose is material to your interest as a member, the information is directly connected to that purpose, and “the member makes a demand in a record received by the company, describing with reasonable particularity the information sought and the purpose for seeking the information.” The company must answer: “Within ten days after receiving a demand pursuant to clause (2), item (ii), the company shall in a record inform the member that made the demand” of what it will provide, when and where, and its reasons for declining any part. A former member may still reach information from the period of membership under subdivision 3 if, among other conditions, “the person seeks the information in good faith.”
• Corporation. Under Minn. Stat. § 302A.461, subd. 4, a shareholder of a corporation that is not publicly held “has an absolute right, upon written demand, to examine and copy, in person or by a legal representative, at any reasonable time” the share register and the documents listed in subdivision 2, which include the required financial statements. The corporation must make those documents available “within ten days after receipt by an officer of the corporation of the written demand.” Other records are available “only if the shareholder, beneficial owner, or holder of a voting trust certificate demonstrates a proper purpose for the examination,” and a court may “specifically enforce this section and award expenses, including attorney fees and disbursements.” Under subdivision 4b, a shareholder may not use the records “for any purpose other than a proper purpose.”

An LLC may impose reasonable confidentiality conditions, but under subdivision 7 of § 322C.0410, “In a dispute concerning the reasonableness of a restriction under this subdivision, the company has the burden of proving reasonableness.” An operating agreement also may not “unreasonably restrict the duties and rights stated in section 322C.0410” (§ 322C.0110, subd. 3). I suggest asking for the company’s tax return, financial statements, general ledger, and capital account records. I also suggest stating your purpose as verifying your allocation and the company’s ability to make a tax distribution, because the manager-managed standard turns on that description. My pages on how to demand company records and on Schedule K-1 errors cover both steps in more detail.

What Are Your Options When the Company Will Not Distribute Cash?

Your options range from a direct conversation with the other owners to a court petition. I suggest starting with the less costly steps because each one preserves the relationship and builds the record a later step needs.

1. Talk to the other owners. I suggest asking for a tax distribution for this year and a standing policy for future years, because a written policy settles the question for later years too. This fits when the relationship still works and the company has cash, and it costs little. I suggest framing the request around the company’s cash position, because the solvency limits in § 322C.0405 and § 302A.551 apply to any distribution.
2. Plan with your CPA. A CPA can estimate the tax on your allocation and set up estimated payments, so the bill does not arrive all at once. A CPA can also check whether the company elected Minnesota’s pass-through entity tax under § 289A.08, subd. 7a. This solves your cash timing, not the company’s refusal.
3. Demand the records. A written demand under § 322C.0410 or § 302A.461 tests whether the company can afford a distribution and whether your allocation is right.
4. Negotiate a tax distribution clause. In an LLC, Minn. Stat. § 322C.0407, subd. 2 provides, “In a member-managed limited liability company,” that “The operating agreement may be amended only with the consent of all members,” and subdivisions 3 and 4 provide, for a manager-managed or board-managed LLC, that “The consent of all members is required to” amend the operating agreement, among other acts. Unless your LLC’s agreement sets another vote, the majority needs your consent for any amendment it wants, which gives you room to ask for a tax distribution clause in the same document.
5. Negotiate a buyout. Resigning does not cash you out, because § 322C.0404, subd. 2, provides that “A person’s dissociation does not entitle the person to a distribution.” Withdrawing “by express will” before the company terminates is wrongful under Minn. Stat. § 322C.0601, subd. 2, and under subdivision 3 a member who does so “is liable to the limited liability company and, subject to section 322C.0901, to the other members for damages caused by the dissociation.” Under Minn. Stat. § 322C.0603, subd. 1, the member’s “right to participate as a member in the management and conduct of the company’s activities terminates,” and, “subject to sections 322C.0504 and 322C.1001 to 322C.1015, any transferable interest owned by the person immediately before dissociation in the person’s capacity as a member is owned by the person solely as a transferee.” A sale on the agreement’s buyout terms, if it has them, or on terms you negotiate is one way out. Option 6 covers a court-ordered sale for fair value. That sale comes in a proceeding that § 322C.0701, subd. 1, clause (5), allows only “on application by a member.” Minn. Stat. § 322C.0102, subd. 15, defines a member as a person that “has not dissociated,” so withdrawing first gives up that option. My page on how to buy out a business partner covers pricing.
6. Bring a claim. A written distribution promise supports a breach-of-contract claim, as in Drewitz. Other routes include an LLC member’s application under § 322C.0701, subd. 1, clause (5), when those in control “have acted, are acting, or will act in a manner that is illegal or fraudulent” or have acted oppressively. They also include a shareholder’s case under § 302A.751, subd. 1, when those in control “have acted fraudulently or illegally toward one or more shareholders” or in an unfairly prejudicial manner, or when “the corporate assets are being misapplied or wasted.” In those statutory proceedings, the remedy is the court’s to shape. For an LLC, § 322C.0701, subd. 2, provides that the court “may order a remedy other than dissolution,” including a sale for fair value. For a corporation, § 302A.751, subd. 1, provides that “A court may grant any equitable relief it deems just and reasonable in the circumstances” or order a buyout under subdivision 2. A claim is the costliest option and puts the relationship at risk, and each claim has its own limitations period.

Phantom Income and Your Next Steps

You owe tax on your share of the profit whether or not your Minnesota LLC or S corporation pays it out. Minnesota law gives an LLC member no right to that cash before dissolution unless the company decides to distribute or the operating agreement requires it. A corporation’s distributions are for its board to authorize, subject to any rights the articles, bylaws, or an agreement set. The operating agreement or shareholder agreement is therefore the first document to read, the company’s records are the second, and a tax distribution clause, a buyout, or a claim is the path from there. Your CPA handles the return and estimated payments. This page is part of my practice on ownership disputes. If you owe tax on profits your company keeps, email [email protected] with a brief description, and I can start an intake and conflict check before you send any confidential documents.