Question: What is phantom income and why is it a problem for creditors?
Answer: For income tax purposes, many LPs and LLCs are considered a “pass through” entity. This means that the company is not taxed on its income, but all taxable income (or loss) passes through and is taxed to the underlying owners.
Each owner includes his or her share of the company’s taxable income and losses on the owner’s income tax return (and this is regardless of whether the LLC makes distributions of cash or property to the owner).
In other words, the owner must report the income even if the company made no distributions of cash (also known as “phantom income”).
When a creditor obtains a judgment against a (partner) debtor, the judgment creditor often receives something known as a “‘charging order”. Essentially, the charging order allows the judgment debtor to step into the shoes of the owner. Depending on the law of the state and specifics of the charging order, a creditor may be considered the owner for income tax purposes but have no say in the management or affairs of the partnership (and usually holds only a nominee interest in the entity). In general, as a remedy, a creditor would want to avoid a charging order where it would potentially be taxed on the partnership income, but not be entitled to any actual distributions from the company to cover the tax liability associated with the income.
As always, if you have any questions or would like to learn more, please let me know.
ABOUT STEVE SHANE
Steve Shane provides strategic counseling to clients in need of estate administration, charitable giving and business continuity planning while minimizing estate, gift, and generation-skipping transfer tax exposure. He offers legal guidance to clients on asset protection and the proper disposition of assets in accordance with the client’s objectives, while employing tax planning techniques such as the use of irrevocable trusts, life insurance planning, lifetime gifts and charitable trust. He is also experienced with drafting documents for business planning, the incorporation and application for exemption for Private Foundations and the administration of decedents’ estates.
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