Phantom Income’s Impact on Law Firm Year-End Financial Planning
Year-End Financial Tips for Law Firms: Part 2
Phantom income is a concept that can complicate year-end financial planning for law firms. It refers to taxable income reported by a firm without a corresponding cash outflow to owners. For law firm partners, this can mean owing taxes on income they haven’t yet received in cash, affecting both the partners’ personal finances and the firm’s overall financial stability.
In this second article in Barto Consulting’s series on year-end financial tips for law firms, we explain why understanding and managing phantom income — and its counterpart, phantom deductions — is essential to ensure a law firm’s financial health and an accurate year-end plan.
What is Phantom Income?
Phantom income occurs when a law firm recognizes income on its financial statements without receiving the corresponding cash. Even though essentially all law firms recognize their income for income tax purposes on the cash basis of accounting, that does not mean that every cash receipt is taxable income, and every disbursement is an expense. Take debt, for example. As you borrow from your line of credit, the proceeds do not create taxable income. The same is true of repayments to the line. Phantom income can come from many different sources, but the implications can be extremely impactful if not planned and predicted in advance.
Generally, phantom income will come in two forms: timing differences and permanent differences.
Timing Differences Impacts Cash Flow and Taxable Income
Timing differences consist of transactions that impact both cash flow and taxable income in the same magnitude, but over potentially different reporting periods. One common example includes client costs advanced. Law firms often pay upfront costs for clients, such as filing fees or expert witness expenses, expecting reimbursement. For tax purposes, these are considered loans to clients. So, while the law firm has parted ways with the cash, there is no cash available to distribute to partners or pay tax deductible expenses.
To describe further, assume a law firm has earned $1million in fees and holds $1 million in cash. To avoid phantom income to its partners, the firm would distribute all the cash (because they will be paying tax on the $1 million).
Now, assume the same firm is working on a large case on which it needs to advance $350,000 in costs for its clients in a contingency matter. In this scenario, the cash available for distributions would only be $650,000 after advancing the costs. Making some additional assumptions about the recipients’ tax situation, a safe prediction is that $450,000 of this will go to pay federal, state, and payroll taxes on this income (the tax is calculated on $1 million). That leaves the partners $200,000 to pay for all other personal use such as insurance, mortgages, car payments, tuition, vacations, etc. For many, that may be plenty of money to get by; but, in any case, when a partner is expecting $550,000 and only receives $200,000, they are bound to be significantly impacted.
On the other hand, the opposite impact will be felt when the client repays the advanced costs or they are written off, albeit that may be the following year or years from the time they are advanced. In this scenario, it is important to ensure that those who were impacted by the initial transaction (those who paid the tax without receiving the cash) are the ones who receive the benefit of the corresponding windfall (cash without the tax or the write off). Even in this simplified example, you can see the complexities of tracking these implications while, in most firms, this is happening at varying levels across hundreds of clients. More on this later.
While investing out-of-pocket case costs may be commonplace for some firms, others rely on lines of credit or other debt to offset this impact. Lines of credit are important tools for law firms in working to offset the impacts of phantom income, as they allow firms to control and smooth the cash available for partner distributions and other important uses of operating cash.
Other transactions that create and offset phantom income through timing differences include certain asset purchases and depreciation, some prepayments of expenses, deposits, debt and repayment of debt, investments, and many others.
Permanent Differences
Permanent differences consist of transactions that will never impact cash and taxable income in the same magnitude. They typically include statutorily non-deductible expenses, such as club dues and entertainment expenses. Firms will pay these expenses as incurred but never receive a tax deduction for them. These expenses also need to be managed and minimized while considering the firm’s tax planning, but their complexities are not as pervasive as those of timing differences.
Why Phantom Income and Deductions Matter for Law Firms’ Year-End Financial Planning
While phantom income impacts an individual partner’s ability to pay taxes, the long-term implications on partner compensation and firm capitalization can be even more significant.
Over time, the impacts of, and disparities in, equity around assigning the effect of phantom income transactions can materialize in each partner’s capital account. To put it simply, phantom income creates capital. It has the same impact as a partner writing a capital contribution check to the firm. Because it would be impossible (or at least impractical) to manage each phantom income transaction individually, capital account management is critical to ensure fairness among partners. A good year-end plan will ensure that ending capital accounts are considered in determining how the firm’s year-end income will be assigned and the amount of cash that each partner will receive. As we have shown, the two should not always be assumed to be the same.
In conjunction with clean financials and a sound method of projecting income and cash flow, having a handle on phantom income and capital accounts will help any law firm design and execute a year-end plan that provides timely, relevant information to owners, allowing them to adequately predict and plan their personal taxes and cash flow (which is discussed further later in this series).
Managing these elements through careful year-end planning allows law firms to align tax liabilities with actual cash flow, supporting healthier capital accounts and preventing financial stress on partners and the firm. By monitoring phantom income and deductions closely, law firms can avoid unexpected tax burdens, stabilize their cash position and ensure a fair distribution of income and tax obligations across all partners.
If you have questions about year-end financial planning at your law firm, email Barto Consulting Principal Consultant and Founder Derek Barto, CPA so that he can help you get your law firm off to a great financial start in the new year.
Previously in this Series
