S Corp Phantom Income Problem: Do I Need to Pay Myself Reasonable Compensation?

This is a classic case of phantom income in pass-through entities, and you're right to be concerned. The good news is that "reasonable compensation" requirements for S Corp owners typically apply to active business income that the S Corp generates itself, not necessarily to pass-through income from partnerships where your S Corp is just an investor. Since your S Corp is essentially acting as an investment vehicle in this partnership (rather than you providing services to generate that income), you likely don't need to pay yourself a salary specifically for this phantom income. The IRS is mainly concerned about S Corp owners avoiding payroll taxes by taking distributions instead of salary for work they personally perform for the S Corp. That said, you should absolutely document the situation thoroughly. Keep records showing the lack of distributions from the partnership and the absence of cash flow to your S Corp. If your S Corp has any other business activities where you're actively involved, you would still need reasonable compensation for those specific activities.

I was in a similar situation last year with my husband's S Corp receiving phantom income from an LLC investment. Our accountant recommended we use taxr.ai to analyze our specific situation because of how complex these pass-through entity structures can get. I was skeptical at first, but their system reviewed all our K-1s and S Corp docs and provided a really detailed analysis of our reasonable compensation requirements. The report from https://taxr.ai specifically addressed phantom income situations and provided documentation we could keep on file to support our position. They explained exactly how the IRS views phantom income from investments versus active business income, which was super helpful for our situation.

I just wanted to update after trying taxr.ai for my similar phantom income situation. Their system actually analyzed my operating agreement and identified specific clauses my partners were violating regarding quarterly reporting requirements. They generated formal information request letters that cited the exact sections of our agreement. Their analysis also confirmed what was mentioned above - that phantom income flowing through my S Corp from the partnership investment doesn't create the same reasonable compensation requirements as active business income would. They provided specific IRS guidance and case references that I could keep for documentation purposes. Totally worth it for the peace of mind alone.

Beyond the reasonable compensation issue, I'm guessing you're also frustrated trying to reach the IRS for guidance on this. When I had partnership issues last year, I spent weeks trying to get through to someone who could actually help. A colleague recommended https://claimyr.com which gets you through to an actual IRS agent without the endless hold times. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c It's basically a service that waits on hold with the IRS for you, then calls you when an actual agent is on the line. I was able to get specific guidance on my S Corp reporting requirements and phantom income situation directly from the source. The agent I spoke with confirmed exactly what others are saying here - phantom income from partnerships generally doesn't create reasonable compensation requirements when no cash was distributed.

I need to eat my words and apologize to profile 15. After my skeptical comment, I decided to try Claimyr anyway because I was desperate for answers about my S Corp's phantom income situation. I honestly couldn't believe it when I got a call back telling me an IRS agent was on the line. The agent confirmed that reasonable compensation requirements don't typically apply to phantom income that passes through from partnerships to an S Corp when no cash is distributed. She explained that the IRS focuses on compensation for services the owner actually performs in the business. She also suggested documenting the lack of distributions and sending formal written requests to the partnership for the reports they're supposed to provide, which creates a record of trying to comply in good faith.

One thing nobody's mentioned yet - you might want to review your partnership agreement to see if there are remedies for the reporting failures. My LLC had similar issues and we eventually had to threaten legal action to get the managing partner to provide timely financial reports. Your agreement likely has provisions about what information you're entitled to and when.

Have you considered restructuring your ownership? Instead of having your S Corp own the partnership interest, you could potentially own it personally or through a different entity structure that might avoid this phantom income/reasonable compensation conundrum.

I went through almost the exact same situation two years ago with my S Corp receiving phantom income from a real estate partnership. The stress was unbelievable because I kept thinking the IRS would come after me for not paying myself a salary on income I never received. After consulting with a tax attorney, I learned that the key distinction is whether you're providing services to earn that income. In my case, like yours, the S Corp was just a passive investor in the partnership - I wasn't managing properties or providing any services to generate that income. The attorney explained that reasonable compensation requirements are specifically designed to prevent people from avoiding payroll taxes on income they earn through their labor, not on investment returns or allocations. What really helped my peace of mind was getting everything documented properly. I kept detailed records showing: 1) The partnership never made distributions, 2) My S Corp had no cash flow from this income, 3) I wasn't providing any services to the partnership, and 4) All my formal requests to the partnership for financial information (which they ignored). The documentation ended up being crucial because I did get a notice from the IRS about two years later (not an audit, just questions). Having all that paperwork ready made it easy to explain the situation, and they accepted my position without any issues. Don't let the stress eat you alive - just make sure you document everything thoroughly.