Phantom income: the tax bill nobody mentions on a PIK NAV loan

This article is general information about how NAV loans are structured. It is not tax, legal or investment advice, and it does not describe the tax position of any particular lender or borrower. Tax treatment depends on the facts, the jurisdiction and the taxpayer, and the rules change. Anyone considering a facility with payment-in-kind interest should take advice from their own tax adviser before signing anything.

Most NAV loans to family offices and GPs are written with payment-in-kind interest. The borrower does not pay cash each quarter. The interest is added to the balance and settled when the portfolio distributes. Borrowers like it because it matches the shape of the collateral. What is discussed less is that the lender is taxed on that interest every year, whether or not a dollar has arrived. The trade calls it phantom income, and it shapes who can lend on a PIK basis and how the term sheet is written.

Where the rule comes from

Under US federal income tax law, a debt instrument whose interest is not paid in cash at least annually is treated as having original issue discount. Interest that is capitalised rather than paid is not "qualified stated interest", so a loan with a PIK feature is an OID instrument from the date it is issued (Treas. Reg. 1.1273-1(c); PKF O'Connor Davies, Hidden tax traps in the current private credit environment, June 2026). The holder of an OID instrument includes a portion of the discount in gross income for each day it holds the instrument, under the constant yield method, regardless of when cash is received (26 U.S.C. 1272(a); Treas. Reg. 1.1272-1). That applies to cash-basis taxpayers as well as accrual-basis ones. RSM's note on the point is blunt: a cash-method creditor holding a PIK note must include the current interest in income regardless of when it receives payment (RSM, Accrued interest vs PIK interest).

So a lender with a three-year PIK loan reports interest income in years one, two and three, and receives the cash in year three. The tax in years one and two is paid from somewhere else.

Why it troubles some lenders and not others

The effect depends on what kind of entity the lender is.

A balance sheet lender, such as a bank or a corporate lending from its own capital, is an accrual taxpayer with other cash income. Accrued PIK is taxable income in the year it accrues, offset by that lender's funding costs and expenses in the ordinary way. There is a timing cost but no cash crisis. This is why balance sheet lenders can run a largely PIK book.

A private credit fund organised as a partnership passes the accrued income through to its investors on their annual tax forms. A taxable US investor then owes tax on income the fund has not received. Carta's guide to PIK in private credit describes the fund-level result directly: accrued PIK interest is generally taxable income for the fund in the year it accrues, even though no cash changes hands (Carta, PIK interest: a guide for private credit).

A business development company has the hardest version of the problem. A BDC that qualifies as a regulated investment company must distribute most of its taxable income each year to keep that status and avoid an excise tax. Accrued PIK counts as taxable income. One BDC's annual report explains that it must include OID and PIK income in taxable income before receiving the cash, and that doing so can require distributions to investors before the corresponding cash is collected (SCP Private Credit Income BDC LLC, Form 10-K for 2025).

The practical result is that PIK is easy for a balance sheet lender, manageable for a fund with the right investor base and structure, and expensive for a vehicle with a distribution requirement.

How lenders structure around it

Mayer Brown's August 2026 note on PIK in fund finance sets out the drafting tools lenders now use, and the same features appear in family office and GP facilities (Mayer Brown, Payment-in-kind interest in fund finance transactions, August 2026).

Minimum cash interest. The most common approach is to require the base rate component to be paid in cash, with only the margin capitalised. The lender receives enough cash to cover tax on the accrual, and the borrower keeps most of the cash flow benefit.

A PIK premium. The margin steps up when the borrower elects to capitalise interest. The premium compensates the lender for the deferred cash and the tax timing, and it can scale with how much interest is capitalised.

A PIK period and a cap. Capitalisation is permitted for a defined period that ends before maturity, with a cap on the amount that can be added to principal and a bring-down of representations each time the election is made.

Fund-level tools. Private credit funds pair PIK loans with cash-pay loans in the same book, make tax distributions to investors from the cash-pay income, and use offshore feeder vehicles for tax-exempt and non-US investors who are indifferent to the phantom income.

Tenor. Keeping the term at five years or less matters for the borrower's side of the ledger, covered next.

The borrower's mirror image

The borrower's position is the reverse. OID accrues as a deduction in the same way it accrues as income to the lender, so a borrower deducts PIK interest as it accrues without paying cash (PKF O'Connor Davies). That deduction is subject to limits, and which limit applies depends on who the borrower is.

For a corporate borrower, business interest including OID is capped under section 163(j), and a PIK loan can fall within the applicable high yield discount obligation rules if its maturity is more than five years from issue, its yield exceeds the applicable federal rate by more than five percentage points, and it has significant OID (26 U.S.C. 163(i)). An instrument caught by those rules has part of its OID deduction deferred until paid and, where the yield is high enough, part disallowed permanently (26 U.S.C. 163(e)(5)). Mayer Brown notes that provisions requiring cash interest at points over the term are typically used to stay outside rules that defer or eliminate the OID deduction (Mayer Brown). The five-year test is one of the quiet reasons NAV facilities tend to be written at three to five years.

For a family holding company taxed as a partnership with individual owners, the relevant limit is usually the investment interest rule in section 163(d), under which interest on debt used to carry investments is deductible only against net investment income, with any excess carried forward (26 U.S.C. 163(d)). Whether gains from the portfolio can be counted in that calculation involves an election and should be checked with the family's own adviser.

What this means in a term sheet

A borrower seeing a term sheet with a cash-pay base rate and a PIK margin, or a PIK premium, or a PIK period that ends a year before maturity, is looking at the lender's response to phantom income rather than at a negotiating position. A lender with a fund behind it needs those features. A lender working from its own balance sheet needs them less and can offer full PIK more readily. Nodem lends from the UK, where companies are also taxed on loan relationships on an accruals basis under Part 5 of the Corporation Tax Act 2009, and from a family office balance sheet rather than a fund with a distribution requirement, which is why full PIK is available on most of our facilities (HMRC, Corporate Finance Manual CFM31000, loan relationships).

None of the above replaces advice. The rules summarised here are US federal rules as described in the cited sources, state and non-US rules differ, the treatment of a given loan turns on its documents, and a lender's or borrower's position depends on its own tax status. Take advice before relying on any of it.