Hi this is Rick Fair with the Fair Law Group in Waco, Texas. Today, I’m going to be talking about Phantom Income in regard to a Texas LLC. This is a topic that really affects multi-member LLCs. And what we’re going to do is start with a couple of basic definitions.
Okay, so first, the idea of Phantom income is something that only specifically affects LLCs and S corporations with multiple members. If you have a single-member LLC, you won’t have any issues with this. So, the first couple things we must understand are a couple of terms that are used for tax purposes you file a tax return, you typically hear these terms in conjunction with LLC tax filings.
First, Allocations: this essentially is recording any income resulting from the LLC that is located to a member of the LLC for tax purposes. And, this does not matter whether that member of the LLC receives a distribution on that income or not. So, let’s sum this up.
Let’s say you’re you’ve got an LLC that makes $50,000 for the first year and you have two members, and each of these members are 50/50 split. So, you would have Member A be allocated $25,000 of that $50,000 and Member B allocated $25,000 left of that $50,000 So basically, 50%.
What you would do is at the end of the year is you tabulate your income, losses, and then figure out what your net profit or net loss is, and you would essentially record these on what’s called a capital account; a nice way of saying it’s a ledger you’ll see this in just a second. I’ll show some examples.
So that’s essentially what it is you take the income the profit or the loss for that year and you will allocate based on each member’s percentage interest on a ledger, commonly known as a capital account.
So, how’s the allocation different than a distribution? An allocation is only there for tax purposes. This is what many in the legal field called a legal fiction that exists for the sole purpose of tracking how much income or loss is associated with each member. Distributions occur when the LLC distributes cash, real property, or any other personal property to a member.
So, we have the two members that we just talked about a second ago, one of these guys makes $25,000, the other makes $25,000; a 50/50 split. And let’s say you know they distribute $25,000 cash to each one, so you’d have in the allocation of $25,000 for each of these members and also the distribution of $25,000 for each of these members, and that capital account ledger you’ll see in a second distribution decrease the capital account. And generally, though there are some exceptions for relatively complex LLCs based on different arrangements, all of these distributions should be made in proportion to the members’ interest in the company.
So, that’s a lot to take in. Let’s look at some examples. So, if you’ve watched some of my previous videos, I’ve talked about Joe and Jim. These are two guys setting up LLC for a plumbing business. And when these names come up, you’ll understand why if you watch the previous videos.
So, let’s look at Joe’s capital account first. So, on the first of the year, he contributed $1,000 to the LLC. So, you can see that his capital account balance, all the way on the far right, increased $1,000.
At the end of the year, the LLC made approximately $50,000. And out of that, he’s a 50/50 member, so he got $25,000 of that. And if you see on the right, again, that capital account balance increased by $25,000 for a total of $26,000.
Now, let’s look at Jim, the other partner. Once again, he’s a 50/50 partner, first of the year he contributes $1,000, so we have a balance of $1,000. And let’s just say, on the 15th of May, he decided to take a distribution of $500. And, what did this do to the capital account balance? Well, it reduces it from that initial $1,000 down to $500. And then, at the end of the year, Jim gets his $25,000 share of the profit. And, you add $25,000 to the existing $500 that’s left in the capital account, and you get $25,500.
Now all of this is going to show two things. The balance is the capital account balance. But what do you report based on this is the question I hear all the time from clients. Well, okay. Before the allocations, it’s pretty simple.
What was the profit from that year look at 12/31/2020, they tabulate is $25,000. So both Joe and Jim are going to report that they were allocated $25,000 each, but let’s remember Joe did not take any distributions that year. But, either way, he’s still stuck with a tax bill on the $25,000.
Same thing with Jim, what’s the difference with Jim? Well, he took out $500. So, still not much for a $25,000 gain, but either way, you’re still going to owe taxes on it. And that’s the whole idea of phantom income – it’s what happens when you have allocations that are made because your LLC made money, but you’re not taking those distributions out.
So, the last example; this just sums up with both of our members here. Joe and Jim are 50/50. They both contributed $1,000 at the beginning of the year, the company made $50,000 for the year, so they’re split $25,000 each. Jim was the only one with distributions and there are our ending capital accounts. This is typically what you’ll see with an LLC is at the end of a fiscal year, though these numbers usually aren’t round.
So, summing this all up. Phantom income occurs when you’ve got more income allocated to a member than what they actually distribute and the IRS rules, essentially say this income is taxable when the income is earned, not when it’s distributed.
I’ll repeat that one more time that’s a very, very important point: income is taxable when the income is earned, not when it’s distributed. This means those allocations matter. They must be correct. And, even though you didn’t take money out from the LLC, you have to report it.
I talked to clients about this and I don’t care if your LLC made $30,000 this year and you kept all the money in there, it’s still technically taxable if you’re in a partnership with more than one person. With single-member LLC’s, it’s also a flow-through entity, but I’ll do a separate video on the tax implications of single-member LLC in Texas. It’s important to note, if there are multiple members, you have to report those allocations.
So, Phantom income is essentially this: you’re reporting all these allocations on your tax return and you’re getting hit with those taxes, even though you didn’t actually take any money out.
So how do you fix that? Well, that’s what we’re going to talk about now.
So, we address Phantom income by looking at the situations in which they arise. Generally, Phantom income occurs in situations where you have LLC members who have day jobs. They don’t rely on the income from that LLC to survive day-to-day. It’s not their primary means of livelihood, and the LLCs are usually holding investment properties, contributing to startups, things of that nature. These are the situations where you see Phantom income arise with LLCs. Granted, S corporations are a different argument altogether and I’ll do a separate video on that. But, if you’ve got an LLC, the best way to plan for Phantom income is to include a provision in your operating agreement that requires the LLC to distribute enough cash every year to ensure each member can pay their outstanding tax liability.
Well, the problem with this is there is no one size fits all way to address this. And, I’ve seen various permutations of these tax distribution clauses on the internet. I’ve actually seen one lawyer do this, where he talks about using the average tax rate in New York City to determine the amount that should be distributed and yeah, maybe if you live in New York, that’s a good idea, but I actually think this guy was talking about Texas LLCs. So, this made me question this methodology just slightly, since it’s not really good to use something that’s foreign to the state you’re in. And, I think if you ever get questioned by the IRS on that, as to why you use certain distribution schemes, they’re going to question why you using somebody else’s state law to essentially figure out how much you’re distributing. I think it could cause more problems than good when you do something like that. The other methods use the average marginal tax rate.
Generally, using the marginal tax rate is the best approach, and we use here at our firm by taking the highest marginal tax rate for the year, based on whatever fiscal year you’re in. Whatever it is, say, it’s 38.5%. I’m not sure what this year’s marginal tax rate is, but say 38.5%, you’ll take 38.5% of the $25,000 that Joe and Jim are distributed and that’s how much the LLC is going to give to each member to be able to pay their taxes. Usually, if a tax distribution clause is working correctly, it’s going to use a mechanism to distribute more than enough to cover the tax liabilities associated with it.
Now, one important caveat is Texas does not have a state tax, so if you’re watching this video about Phantom income and you’re from another state. I cannot speak about any issues of state taxation because we here in Texas don’t have that. I’m only licensed here in Texas as an attorney, so your mileage may vary on that that once again that just goes to say that the best way to plan for Phantom income is to actually sit down with somebody and say, okay, this is where our members live, these are the situations we’ve got, and what you try to do is say, what is the highest potential tax rate that anybody will deal with? And, then that’s the marginal tax rate you’d use for it to be fair and equitable. Now, another important distinction and this is something I’ve seen a lot of people pass by in operating agreements, is the notion that you can’t essentially bankrupt an LLC to make distributions.
The Texas Business Organization Code (TBOC) has a very strict provision stating you cannot liquidate the LLC just to make distributions to members, or you cannot go as far as saying, we’re going to borrow money just to distribute money to the members. It doesn’t work that way; the TBOC doesn’t allow it. And, most of these online operating agreements I’ve seen, even some of the attorneys who have put their stuff up, they’re missing that very, very important provision there.
I know it’s in the TBOC, but the reality is, it’s better to get it in writing in the operating agreement and not rely on dealing with a lawsuit later by another member because another member that may be the managing member may have decided to distribute and put the LLC in debt just for distributions. Those lawsuits happen, and it’s best just to get it in writing, so it’s very fundamentally clear to everybody that you cannot take on debt for the LLC to make distributions.
These distribution clauses are all well and good, but the reality is, you cannot put the LLC in debt to pay a member. You’ve got to have cash on hand. And, if the LLC is operating the way it should, you will have cash on hand to make these distributions.
So, how does Phantom income play into asset protection? This is a question I get asked a lot by clients who are specifically interested in asset protection. Well, you’ve got to carefully plan for this and in recent years I’ve been very reticent to recommend doing tax distribution clauses by classes. But as case law becomes clearer, I feel more comfortable doing these types of distribution clauses now.
Specifically, what you would want to do is split your membership interest into classes and I’ll do a separate video talking about that whole idea of class splits and LLCs. They’re absolutely allowed and a good idea for asset protection purposes. But, to sum it up really quickly, you’d want to preferred and non-preferred membership interest class, and the preferred class would be pretty simple, it’s your voting members it’s the ones that have the right to distributions. And, the ones that you would want to prefer to get distributions, essentially. Well, your non preferred would essentially be someone who could gain membership interest, say a creditor of a member or a divorced spouse, these are the types of non-preferred people we’re talking about.
These are people who could come into possession of membership interest in the company and that’s a whole different video, but you want to ensure that they don’t receive mandatory distributions by this tax distribution clause. In years past it was questionable whether you could restrict the tax distribution clauses, but recent case law made it clear that you can, so it’s a good idea to carefully plan with tax distribution clauses to essentially prevent a creditor of a member or divorced spouse from essentially getting a distribution windfall to pay their taxes. And honestly, it’s another way to dissuade potential creditors or divorced spouses from trying to take a membership interest in the company anyway.
If you’re doing your operating agreement right for asset protection purposes, a creditor or divorced spouse is going to look at that membership interest and say, okay I’m not going to get anything out of it anytime soon. And, even if I did, I’m going to have to pay taxes on it, and I don’t want that headache. That’s the idea. But, that’s summing up a huge portion of what we typically put in our operating agreements and it’s not something you’re going to go readily find out this information on the internet, especially regarding class splits. I have yet to find one operating agreement on the internet that’s done this right. So, if you’re interested in asset protection and things of this nature, it’s best to consult with an attorney about this because it could be screwed up. And, it could lead to some very, very unintended consequences which we often been hired to fix. So, that’s another aspect of Phantom Income and how it can play into the whole asset protection scheme.
That’s all I’ve got for today. So, if you have any questions about LLCs, starting an LLC, or need an operating agreement, anything of that nature. Just look at our information below and give us a call. We’d be happy to help you. Have a good day.