The Atlanta tax attorneys as well as the Atlanta Business Attorneys at The Libby Law Firm are always informing, educating, and assisting individuals and business owners about incurring taxable income (tax liability) without the liquidity to pay taxes on this income. This scenario can be a taxpayer’s worst nightmare and often generates significant internal struggles, infighting, and conflict between business owners. The Atlanta business lawyers and Atlanta tax lawyers at our Firm refer to the scenario of incurring tax liability without producing the liquidity to pay these taxes as “phantom income.” “Phantom income” means you have taxable income but no cash to pay taxes on this income.
“Phantom income” occurs most frequently in Subchapter S corporations and limited liability companies (LLCs), which are presently the most common and popular business entity forms for doing business in Georgia. This is especially true in small businesses owned by taxpayers who may not be aware how “phantom income” can be incurred or what “phantom income” is.
“Phantom income” occurs when Subchapter S corporations and LLCs are taxed. The income in these business entities is passed to the owners whether or not cash is actually distributed to the owners. Moreover, if a business makes a profit, at least for tax purposes, but the business owner(s) keeps most of the money in the business as so often is the case (especially in small businesses), then a “phantom income” scenario can result.
For example, suppose your business has a tax profit of $100,000, but you only distribute $10,000 because you need the rest of the money in the business to keep operating the business. However, you are taxed on $100,000 even though you only received $10,000. This is one instance where you have been the unknowing casualty of “phantom income.”
Thus, the question arises: How do you avoid phantom income? The answer is the proper drafting and prudent use of a well-crafted operating agreement.
If you are a majority business owner, avoiding “phantom income” can be easy. You, as the majority business owner, control the distribution of money from the business and distribute cash to yourself sufficient to pay your tax. However, if you are a minority business owner, you are at the mercy of the majority owner as to whether and/or when cash will be distributed to the owners. If the majority owner does not need the cash to pay his or her taxes (even though he has phantom income as well), then you are at risk of a “phantom income” situation. Therefore, a minority owner should insist on a “minimum distribution clause” in the corporate or LLC operating agreements or other governing business documents. Typically, these clauses require a distribution of at least 40% (forty-percent) of the amount of profit allocated to you. This gives you at least enough cash to pay your taxes.
A final word of caution is as follows: Be sure the majority owner’s typical right to amend the business operating documents excludes the right to amend the minimum distribution clause. Otherwise, “phantom income” may reappear.
Atlanta tax attorneys and Atlanta business attorneys should take great care not to place their clients in a “phantom income” situation. This is why you must choose Atlanta tax attorneys or Atlanta business attorneys who understand the complexity creating operating agreements for Subchapter S corporations and limited liability companies (LLCs). Our Firm assists clients in creating operating agreements that will protect the interests of the business owners while not creating unnecessary and troublesome tax complications and liability for any of the business owner(s). Our Firm can also assist you in any “phantom income” situation in which you may find yourself. We will work closely with you to find a resolution to any “phantom income” state of affairs in which you may find yourself. Our Atlanta business lawyers and Atlanta tax lawyers and experts will work closely with you on these matters. We can assist you in negotiating a resolution to your “phantom income” tax problems with your business partners, find a way to assist you in dealing with the IRS or Georgia Department of Revenue and take measures on your behalf so a “phantom income” tax situation does not reoccur.
The Libby Law Firm strives to be at the top of the Georgia business and tax law firms and prides itself on cost-efficient and cost-effective legal representation. Our Firm can advise, assist, and protect you and your business as well as minimize your liability for tax purposes. We would welcome the opportunity to assist you with your tax and business matters. Please feel free to call our Firm at (404) 467-8611 or to discuss your options. You can also send us a message through our confidential Web Site Form. Our Firm is conveniently located in the Buckhead section of Atlanta, Georgia, near the intersection of Piedmont and Roswell Roads.