Cash compensation arrangements for small businesses can oftentimes generate 'phantom income' for the owners. In order to reconcile cash with taxable income, sophisticated calculations by an experienced professional are necessary. In the long run, understanding the mechanics involved will prevent tax headaches and lighten tax bills for owners.
Imagine two owners are starting a new business together—a professional services firm. They agree to track revenues separately, while splitting expenses 50:50. If Owner 1's caseload brings in $100,000 of income, and Owner 2's caseload brings in $200,000 of income, and total expenses are $100,000, then Owner 1's take-home pay is $50,000, while Owner 2's take-home pay is $150,000. Net income equals $200,000. Let's assume the year has come to an end, and the company has all $200,000 of the company's net income in the bank. The owners divvy up their profits. What is wrong with this picture?
If the owners are 50:50 business partners, then Owner 1 is going to be taxed on fifty percent of net income, or $100,000. Owner 1 only made $50,000, but is paying the tax on $100,000. Conversely, Owner 2 pocketed $150,000 but is only paying tax on $100,000. In other words, Owner 1 is paying tax on ‘phantom income.’
Read: Phantom Income: The Ghoul'd, the Bad, and the Ugly
The problem illustrated above has a solution. However, as the problem is itself a moving target, so is the solution. This example is simplified to illustrate the problem of phantom income as it relates to cash compensation arrangements and pass-through taxation. In practice, the calculations are cascading and complex.
In theory, the solution is also simple, but in practice is always imperfect. So what is the solution? Payroll. By pushing $100,000 of net income back through the company as wage compensation to Owner 2, the company's net income is matched to the net cash compensation amounts. Owner 2 pockets the additional $100,000 that was creating the cash differential, and Owner 1's phantom income is eliminated.
The cost to cure phantom income? It depends. In this example, the cost is likely the full cost of self-employment tax, or 15.3%. However for most professionals with sophisticated compensation arrangements, salaries are already in excess of the social security wage limit ($127,200 for 2017). Therefore, the cost of curing phantom income would only be 2.9% of the compensation corrected through payroll.
If you are starting or joining a service-based firm in an ownership capacity, consider embracing cash compensation arrangements as a tool to manage and grow your business.