The Trap of Phantom Income in Poorly Drafted LLC Operating Agreement
In the complex world of LLC Operating Agreements, one of the most misunderstood and overlooked issues is the concept of “phantom income.” At Fox & Moghul, we’ve seen too many operating agreements that leave members exposed to this hidden financial trap, which can lead to significant tax liabilities without any actual cash in hand. Thus, in this blog, we’ll explore what phantom income is, how poorly drafted LLC Operating Agreements can leave members vulnerable to it, and how Fox & Moghul can help you avoid these pitfalls through meticulous drafting and review of your operating agreements.
What Is Phantom Income?
Phantom income, which is also known as “phantom tax” or “phantom gain,” refers to income that a taxpayer is required to report to the IRS and pay taxes on, even though they haven’t actually received any cash. In the context of LLCs, this can occur when profits are allocated to members on paper but are not actually distributed in cash. The member still has to pay taxes on these “profits,” even though they haven’t received any real money to cover the tax bill. Here is what the IRS regulations state about this issue. See here.
Undistributed K-1 Income – Schedule K-1(Form 1065) and Schedule K-1(Form 1120-S) are used to report each individual partner, shareholder, or LLC member’s percentage share of partnership or S-Corp. income. The individual partner, shareholder, or member must report this amount on their individual income tax return even if these funds were never distributed by the business entity, this is sometimes referred to as “phantom income.” The amount reported on the K-1 should be used as a source to verify an individual taxpayer’s income. If the taxpayer indicates they did not receive the amount reported on the K-1, an adjustment may be necessary to remove the undistributed income from the future income value on the IET. The use of any undistributed K-1 income must still be determined. If the partnership, LLC, or S Corp. is still holding undistributed K-1 income in a bank or other account then the amount of cash being held may be added to the AET as an individual asset. If the undistributed funds were used to purchase an asset in the business name then the asset may be considered when determining the value of the taxpayer’s interest in the business, see IRM 5.8.5.8(5) above.
The Problem with Boilerplate Operating Agreements
Many LLC operating agreements are built on standard templates that fail to account for the specific needs and financial realities of the members. These templates often contain boilerplate language that doesn’t adequately protect members from phantom income.
For example, consider a hypothetical provision found in a poorly drafted operating agreement:
all distributions shall be made at such time as is determined by the Managing Member. Distributions of the Company assets may be made only to the Members shown on the books and records of the Company. Neither the Company nor any Member will incur any liability for making distributions in accordance with the provisions of the preceding sentence, whether or not the Company or the Member has knowledge or notice of any transfer or purported transfer of ownership of a Membership Unit in the Company which has not been approved pursuant to this Agreement. Notwithstanding any provisions above to the contrary, gain or loss of the Company realized in connection with a sale or other disposition of any of the assets of the Company will be allocated solely to the parties owning Membership Units in the Company as of the date, the sale or other disposition occurs. All amounts withheld pursuant to the Code or any provisions of state or local tax law with respect to any payment or distribution to the Members from the Company shall be treated as amounts distributed to the relevant Member or Members pursuant to this Section. No distribution shall be declared and paid unless, after the distribution is made, the assets of the Company are in excess of all liabilities of the Company, except liabilities to Members on account of their contributions.
This kind of language can be problematic for several reasons:
- Discretionary Distributions. Notice that the language in the provision makes distributions completely discretionary based on the whims of the manager, without any provision allowing for a minimum disbursement to the members to allow for payment of taxes to the profits/losses allocated to that member. This leaves the member in a situation where he has to potentially pay taxes on distributions never received.
- Allocation Without Distribution: The provision may require profits to be allocated to members, but it doesn’t obligate the company to actually distribute cash. This leaves members responsible for paying taxes on income they never received.
- Restrictive Distribution Clauses: The clause stating that no distribution will be made unless the company’s assets exceed its liabilities can lead to a situation where profits are allocated but not distributed, creating phantom income.
Example of Phantom Income: Let’s illustrate how phantom income can occur using a typical example:
Suppose an LLC has two members, Alex and Jamie, who are each allocated $100,000 in profits according to the operating agreement. However, the LLC decides to retain all profits within the company to reinvest in the business, meaning Alex and Jamie receive no cash distributions.
Despite not receiving any actual money, Alex and Jamie must still report the $100,000 on their personal tax returns and pay taxes on it. This is phantom income—taxable income that exists only on paper, with no corresponding cash flow to cover the tax liability.
The Impact:
Phantom income can lead to severe financial strain for LLC members, especially if they are unprepared for the tax bill that follows. It can also lead to disputes among members, particularly if the operating agreement did not make the potential for phantom income clear.
At Fox & Moghul, we understand the importance of drafting operating agreements that protect members from such scenarios. We ensure that all financial allocations and distributions are structured in a way that avoids phantom income, allowing members to enjoy the fruits of their investment without unexpected tax burdens.
How Fox & Moghul Can Help
Our team at Fox & Moghul specializes in drafting and reviewing LLC operating agreements with an eye for potential issues like phantom income. We work closely with our clients to understand their financial goals and ensure that their operating agreements are designed to protect their interests.
Here’s how we can help:
- Custom Drafting: We avoid the pitfalls of boilerplate agreements by drafting custom provisions that reflect the specific financial realities of your LLC.
- Clear Allocation and Distribution Terms: We ensure that your operating agreement includes clear terms for the allocation and distribution of profits, so all members are aware of their financial responsibilities and protections.
- Regular Reviews: As your business grows and evolves, we offer regular reviews of your operating agreement to ensure it remains aligned with your current financial situation.
- Tax Planning: We have a team of qualified CPAs who provide tax planning advice to help you anticipate and prepare for any potential tax liabilities, including phantom income.
Conclusion
Phantom income is a real danger that can catch LLC members by surprise, leading to significant tax liabilities without the benefit of actual cash flow. Don’t let poorly drafted operating agreements leave you exposed. At Fox & Moghul, we bring our extensive experience and expertise to the table, ensuring that your LLC operating agreements protect you from phantom income and other financial pitfalls. Contact us today to discuss how we can help safeguard your business and financial interests.
