The Risks of Phantom Income and Phantom Tax - FAQ

An issue that often arises when using a passthrough entity is phantom income. Often a problem for LLCs, S Corps, and partnerships, phantom income occurs when the business entity reports a yearly profit, yet the owner or investors in the business do not receive cash reflecting the allocation. The IRS still taxes the full amount of the business’s income, making business members responsible for paying tax on income they have not received.

What is Phantom Income?

Quite simply, phantom income is a tax liability for a partnership or individual on income that has not been distributed to them.

How Does Phantom Income Occur?

Phantom income can come into play in a variety of circumstances, but we see it most commonly when a business is profitable but growing, a situation where a company will want to reinvest its profits into further growth.

Okay, Be More Specific…

Here’s a real world example: You’ve invested in ABC, LLC, which is taxed as a partnership, and you own 50% of the membership interests. At the end of the fiscal year, the LLC reports net profits of $200,000. Hooray! Wisely committing to growth, the managers of the company have decided those profits are needed to grow the company, thus they won’t be making any distributions to owners. As a member you’ll still receive a K1 that allocates $100,000 (50% of the net income) to you. Despite not having received any money, you’ll still be responsible for paying tax on that $100,000.

Yikes! What Do I Do About It?

Unfortunately for our character in the above example, it’s important to thoroughly plan ahead and exercise due diligence with any business opportunity. Harmony Group can tell at a glance from a business’s books whether there is a risk of significant phantom income.

With any passthrough entity, you should strongly consider adding a tax distribution provision to your operating agreement or shareholder agreement. This is a clause requiring a company to distribute at least some amount of any reported profit to its members or partners - a percentage allowing members to pay their tax bill.

Okay, Tax Distribution Provisions, Got It. For How Much?

It’s often recommended this amount equal the highest combined marginal rates that any member is taxed at, but we recommend setting it as a flat rate - 40%. This is for simplicity’s sake, as members may live in states with different tax laws or themselves have different financial and tax situations. A flat rate of 40% ensures that at the end of the year when you have $100,000 of taxable income as in the above example, the partnership will send you 40%, or $40,000, allowing you to cover your tax bill.

Sounds Great. Sum It Up For Me?

As a member or owner of any passthrough entity, it’s important to plan ahead for phantom income by adding a tax distribution clause to your operating agreement. This clause requires the business to make distributions to cover tax liabilities on allocated but undistributed income. These considerations are most common for entities that are profitable but still growing. More to the point, Harmony Group can help determine whether phantom income is a significant risk for you and your business and help you plan ahead to avoid all sorts of unnecessary tax headaches.

Big Changes to the Child and Dependent Care Credit

Along with the expansion of the Child Tax Credit we flagged last week, the American Rescue Plan is also massively expanding the Child and Dependent Care Credit for 2021. The IRS has released a fairly comprehensive FAQ, but the long and short of it is that if you pay for childcare in 2021, you’re going to be entitled to claim a hefty refund: a median income household with two kids under 13 will receive up to $8,000 back in the cost of paying any childcare provider while working or looking for work. Compare this with the previous structure, where they’d have qualified for a maximum of $1,200, and the benefit is obvious.

The finer details: Any household making less than $125,000 per year will receive up to $4,000 for one child under 13, and $8,000 for two or more when they file for 2021.  The amount you receive back will be 50% of the amount you spend on qualified expenses - so if you spend $10,000 on daycare, you’ll get $5,000 back on your 2021 tax return. This benefit applies only to taxpayers who are working or looking for work (both parents must be working if a couple is married), and is intended specifically to defray the costs of child care, whereas the Child Tax Credit (which we told you about in last week’s email) is simply free money for those who have children. 

Taxpayers must have earned income to qualify, and must provide documentation (including a TIN or EIN) from their childcare providers, so your qualified expenses must be with licensed providers.  These expenses are a bit more expansive than just daycare, however - think after school care programs, summer day camps, etc.  

Another important change, and one of the drivers for notifying our business clients about this credit: the Child and Dependent Care Credit is fully refundable for the first time, meaning the full value of the credit is available to low-income working families, regardless of how much they’re paying in 2021 taxes. Once again, this makes it important to spread the word.

As of now the expanded parameters only apply to the 2021 tax year, but making many of these changes permanent is a priority of the current administration, so expect to hear a lot more about these programs as the year rolls on. For more info you can read the IRS’s full guidance, and stay tuned to our blog for more news as it happens.

The Child Tax Credit Can Save You And Your Employees Thousands

Distribution of the Child Tax Credit begins next month for all eligible Americans. We wanted to take a moment to flag this vital monthly payment for you and your business for a handful of reasons.

First, and most obvious, it’s free money to help anyone raising a child. You’ll be hearing a lot about the credit next week, as the White House has announced Child Tax Credit Awareness Day on June 21st. Where typically this money was offered as a tax deduction at the end of the financial year, it’s now being distributed in the form of monthly payments, and substantially expanded - for the current tax year, families will receive $3600 in total for each child under the age of 6, or $3000 for each child between 6 and 17.

Beginning next month, families will be sent a monthly portion of the credit in installments of up to $300, through the end of the year. A handful of specific wrinkles and stipulations apply, so if you’re confused about whether you qualify, don’t hesitate to reach out. That said, this is the most expansive increase of the Child Tax Credit to date. If you filed taxes last year, you don’t have to worry about signing up or qualifying, as everything is automatic.

Which brings us to the second important point - if you didn’t file taxes last year, the IRS has established a helpful online tool to register to receive payments. Those who qualify to use the tool: 1. Did not and do not plan to file a 2020 tax return, and 2. Have a main home in the US for more than half of the year.

Many of our clients’ businesses will have employees who this applies to - part time, low income, non-filers for whatever reason will be able to take advantage of the credit, so it’s important to spread the word.

For more info you can read The New York Times’ thorough breakdown of the new rules and the White House’s own fact sheet. As ever, follow our blog for up to date information and don’t hesitate to reach out to your Harmony partner if you have questions.

CPA Eats Client Press Roundup

We’re singing the praises of some of the amazing people we work with and their well deserved accolades!

Esquire Names Tiki TNT One of the Best Bars in America - Hailing Tiki TNT’s “raucus, Tiki-fueled times” brought to you by one of the DMV’s “OG cocktail mavens,” Esquire gets it right on the money about our favorite waterside cocktail bar/distillery/restaurant.

The Point is One of Tom Sietsema’s 7 Favorite Places to Eat - Longtime Washington Post food critic in chief Tom Sietsema is almost as crazy about The Point as we are, having already given it a glowing review in the paper earlier this month. We’re inclined to agree about this “crab lover’s bonanza.”

CPA Eats Clients Are All Over Washingtonian’s Best Softshells List - Speaking of crabs, Anju, Elle, Reveler’s Hour, and Pogiboy round out Washingtonian’s list of best restaurants for this hyper-seasonal treat.

We’re Proud to Work With Eight of DC’s Michelin Stars - Last but absolutely not least, we’re thrilled that Rooster & Owl, one of our newest clients, picked up a Michelin Star this year. Along with Pineapple & Pearls, Kinship, Little Pearl, Rose’s Luxury, and Tail Up Goat, we’re honored and proud to work with so many of the restaurants on this vital list, as well as Michelin Bib Gourmand newcomers Queen’s English and Elle.

The SBA Releases RRF Guidance

The SBA has released the first official guidance on the Restaurant Revitalization Fund, which is the $26B restaurant support program that was included in the most recent stimulus bill. They've also posted the portal for the applications to the program. Find the information here. We know many of you have been eagerly awaiting the release of these details and are looking forward to getting support from the RRF. Details on cross-program eligibility and other SBA programs can be found here.

The portal has been posted today but will not be live until the end of the month while the SBA continues development and outreach about the program. We expect the sequence to proceed roughly as follows:

1. April 17-April 30: Outreach, development, and applicant document preparation

2. May 1-21: Exclusive 21 day ‘equity’ period for processing of applications by entities owned 51%+ by women, veterans, and disadvantaged individuals.

3. May 22+: Processing for applications from entities with any sort of ownership

Most of you have seen the various summaries that have been distributed by the National Restaurant Association, the Restaurant Association of Metropolitan Washington, the Independent Restaurants Coalition, and other trade groups. You may also have seen the draft applications and information that were circulated widely, as well - we chose not to comment on them, as, if there’s one thing we’ve learned in 2020, it’s that stimulus program rules change from day-to-day as the programs are created. The gist of the program remains very simple: the SBA will be issuing grants to eligible applicants to cover expenses. These grants will be equal to an applicant’s decline in sales from 2019 to 2020, minus any PPP assistance already received. For applicants that don’t fit the pure ‘we were open through all of 2019 and 2020’ mold (including restaurants that opened partway through 2019, restaurants that opened in 2020, and restaurants that aren’t even open yet, but incurred costs) the calculations work a bit differently, but the spirit is the same. 

The SBA is hosting a webinar and information session this Wednesday, 4/21 at 3:30pm in collaboration with RAMW, Restaurant Association of Maryland, and the Virginia Restaurant, Lodging, and Travel Association, specifically for operators in this region. Registration is required to join the webinar and Q&A. Click here to register. You will receive a link to join the webinar as the event approaches on Wednesday.

For all retainer clients, we anticipate prepping our teams to help you with the application process to ensure your applications are submitted immediately upon opening of the portals, as funding for the program is limited.

Dependent Care Credit Changes for 2021

One of the less promoted aspects of the American Rescue Plan Act was the significant enhancement of the child and dependent care tax credit for 2021. The expanded credit is dramatically more valuable, and now refundable as well, so I wanted to share details on how it works so we can help you maximize its value to you.

What is the Child and Dependent Care Credit?
The Federal government provides a tax credit to reduce your child or dependent care costs. This is a direct reduction of your Federal Income Tax liability.

Why is this tax change a big deal? 
Previously, the credit was much smaller than it is now. It phased out starting at $15,000 and was only good on the first $3k of expenses, so many of our clients had only $600 or $1,200 of max value for it...so it was helpful, but it didn’t really move the needle on child care decisions.

All of a sudden it’s worth as much as $8,000 for a family with two kids, so it can really help out this year... we think it is especially important for clients looking (right now!) to make decisions regarding summer care options for children.

What expenses qualify for the Dependent Care Credit?
Expenses that are ‘employment-related’ costs of taking care of your qualifying dependents qualify. The typical expenses that qualify for the credit are payments to a day-care center, nanny, or nursery school. The cost of kindergarten or above doesn't qualify because it's primarily an education expense. However, the cost of before and after school programs may qualify as care expenses. Summer day camps qualify.

What does ‘employment-related’ mean? 
The expense must enable you and your spouse, if you have one, to work. This means that a family with a non-working parent cannot claim the credit (unless they’re in school full time, but ask us about those rules). 

Who are ‘qualifying dependents?’
Qualifying dependents are generally children under 13 (or a handicapped spouse or dependent) who lives in your household for over half of the year. 

How much is the Dependent Care Credit?
The credit is 50% of up to $8,000 you spend on one qualifying dependent or 50% of up to  $16,000 you spend on two or more qualifying dependents. That means you can get back up to $4,000 for one child or $8,000 for two children.

What are the income limitations?
If your AGI is $125,000 or less, you get the full credit.
If your AGI exceeds $125,000, your credit percentage (which starts at 50%) drops by 1% for every extra $2,000 (or fraction thereof) of AGI you have, down to a floor of 20%.
If your AGI exceeds $400,000, your credit keeps dropping by 1% for every extra $2,000 (or fraction thereof).

Examples: 

• Taxpayer A makes $90,000 of AGI.

  • Taxpayer A’s AGI is less than $125,000, so Taxpayer A gets a full 50% credit for any eligible Dependent Care Costs.

• Taxpayer B makes $135,000 of AGI.

  • Taxpayer B’s AGI is $10,000 higher than $125,000, so Taxpayer B gets a 45% credit for any eligible Dependent Care Costs. (Calc = $10,000 overage / $2,000 = 5 % reduction)

My child stays with my mom/sister/cousin/friend during the summer. Can I pay them and claim the credit?
Eligible Dependent Care Expenses must be from legal child care sources. You must provide the care-giver's name, address, and social security number (or tax ID number if it's a day-care center or nursery school). A day-care center must be in compliance with state and local regulations.  

Is the credit refundable?
Yes! This credit can be directly refunded to you when you file your 2021 taxes.

How can I maximize the value of the Dependent Care Credit for my family in 2021? 
If you have children under 13, some of the most common options to max out this credit are as follows:

• If you have a child below the kindergarten age, nursery school / nanny / daycare expenses will all qualify for the credit (even if the school has a significant educational component)

• If you have a child from Kindergarten through age 13, expenses that aren’t for education can be covered. After school care, for example, generally qualifies.

• The full amount paid for a day camp in summer, even if it specializes in particular activities like computer or lacrosse camp, will qualify if they enable the parent(s) to work. Overnight camp costs are limited to the part of the day that the parent(s) are working.

While the expanded credit is currently only available for 2021, we expect that an extension of the credit will be built inside of the coming infrastructure bill or the next major spending bill, so it is likely that these rules can help you for several years to come.

Maryland Relief Grant Applications Open 3/30 at 9am

Business Clients in Maryland -

I wanted to send a quick notice to small business clients in Maryland that applications for the Maryland Small Business COVID-19 Relief Grant Program will open tomorrow morning at 9am. Harmony Group is not legally allowed to apply to this grant on your behalf (as the State says it will reject applications not signed by someone legally able to bind your company), so we highly encourage any clients that believe they’re eligible to set a calendar reminder/alarm and submit their applications first thing in the morning.

The applications will be available tomorrow morning at the following website:

https://commerce.maryland.gov/fund/small-business-covid-relief-grant-program

This program only has $10,000,000 allotted to it, so it is anticipated that the money will be allocated to businesses that apply tomorrow morning.  If you do not have a copy of your 2019 business tax return handy, please login to your Harmony Group Canopy portal to download it or email the tax administrator at admin@harmonycpa.com. Full details of grant eligibility and application requirements are below.

Best Regards -
Matt

GENERAL TERMS AND CONDITIONS
Eligible applicants must be a Maryland based for profit business which primarily engage in non tangible services not subject to the Maryland sales and use tax.

• Must have between 1 and 20 employees;

• Must have at least 1 W2 employee and the business must have an active account with the Maryland Department of Labor’s Division of Unemployment Insurance;

• Must demonstrate a 25% or greater reduction in revenue adjusted for COVID-19 costs such as sanitation, PPE in 2020 over 2019;

• Must be established prior to March 9, 2020;

• Must be registered and in good standing with Maryland SDAT;

• Applicants who did not receive a COVID-19 Business Relief Grant or Loan will be prioritized over applicants which received a COVID-19 Business Relief Grant or Loan from the Maryland Department of Commerce;

• The applicant, affiliates, subsidiaries, and parent company of the applicant must have combined revenues less than $5 million in 2020;

• Economically disadvantaged applicants as defined by personal net worth of $750,000 or less, adjusted gross income of $350,000 or less, and $6 million or less in assets will be prioritized;

• Business must have an eligible NAICS code as defined and categorized by North American Industry Classification System;

• Applications will be prioritized by industries most impacted by COVID-19;

• Business must currently be in operation;

• Business must have a physical Maryland location;

• Funds will be distributed to the extent practicable by Commerce, among the counties based on population; and

• Your application will be rejected without further review if the application is incomplete and not signed by a person with authority to bind your business.

APPLICATION
To apply, a business must complete the application provided on here starting March 30. At minimum, a completed appliation must provide:

• A valid Maryland unemployment insurance number and proof of at least one W2 employee, which may include the owner;

• 2019 Federal Tax Return or 2019 Profit and Loss/Income Statement prepared in house or by a CPA;

• 2020 Federal Tax Return or 2020 Profit and Loss/Income Statement prepared in house or by a CPA;

• Certificate of Good Standing with Maryland State Department of Assessment and Taxation;

• Business NAICS code as defined and categorized by North American Industry Classification System;

• An explanation of how COVID-19 has impacted your business and the purpose of the grant;

• As part of the application, you will be asked to provide a list of specific expense items such as rent, fixed debt payments (p+i), payroll expenses, other taxes and fees, utilities, equipment repairs, supplies, and other cash expenses.

The SBA Defers All EIDL Payments Until 2022

The SBA has announced that it will defer all Economic Injury Disaster Loan (EIDL) payments until 2022. Payments were initially due 12 months from the date of the note, and this deferral applies in two ways, depending upon which calendar year the loan was made:

• If your SBA disaster loan was made in 2020, the first payment's due date has been extended another 12 months, to 24 months from the date of the your note.

• If your SBA disaster loan was made in 2021, the first payment's due date has been extended another 6 months, to 18 months from the date of the note.

This will of course affect most of our business clients, and Harmony Group will be there to advise - we're expecting the rules to continue to change over time and further forgiveness is possible. We'll continue to update you as the SBA continues to update all of us.

You can read the full text of the SBA’s update intheir press release about the deferments.