Why do experts say that the C corp is the best vehicle for avoiding phantom tax
I’ve recently been asked why some experts say that the C-corp is the best vehicle for avoiding phantom tax. In response, I thought to provide a series of blog posts exploring this and related topics. Here is the first installment.
The fact is, when investing or engaging in business, you may have to choose among evils. Phantom tax is one hobgoblin for which the C-corporation may be the only true talisman.
Phantom tax is an accounting notion that seems to defy logic: it is the tax liability created when an investor receives value on paper without receiving any actual dividends. Here is an example of the principle: let’s say I have $50,000 in law school loans (not that outlandish!), and due to financial hardship, $25,000 of those loans are forgiven. Theoretically my assets have risen, because on paper I now have $25,000 less I have to pay. If I am taxed on the ephemeral “income,” of $25,000, that tax would be phantom tax.
In business, phantom tax is created when pass-through entities like LLCs and S-corporations post income that gets charged to the investor. Pass-through entities, also known as flow-through entities, are legal business entities in which the income, losses, deductions, and credits are passed on to the owners or shareholders. Only the owners or investors are taxed on the income generated, not the entity itself. In cases where a profitable entity’s distribution of dividends is solely at the discretion of its manager (as it often is), its investor may be left with no cash receivables to pay the tax.
One way around this dilemma for LLC investors is to look for a tax draw clause in the LLC by-laws. In the presence of a tax draw clause, in cases where the tax is still due, provision is made in the bylaws for the LLC to cover the tax.
Many equity investors prefer to invest in traditional C-corporations in order to avoid surprise tax liability. The C-corporation is a legal entity that is separate and distinct from its owners and investors, and is subject to its own independent tax liability. Corporate income is thus taxed to the C-corp prior to distribution to shareholders. Because the C-corp is by nature not a pass-through entity, its investors are not subject to the phantasmagorical income that leads to the generation of phantom tax.
Of course, what one hand giveth, the other taketh away: investors who favor C-corps over pass-through entities may still be subject to double taxation of their dividends.