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Ed Johnson
Ed Johnson, Tax Preparer
Category: Tax
Satisfied Customers: 10760
Experience:  GPHR Cert; U.S. Treasury Tax Advocacy Panel appointee
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My son was part of a LLC business in California (smog shops)

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My son was part of a LLC business in California (smog shops) and the business sold on 9/30/08.   He received his W-2 along with a K-1 indicating a profit of $11,000.00 from the sales of the business.   We contacted the other co-owners and they indicated that the monies, his share, was used to pay their personal loans when the business was bought.   They received a total of $33,000 and it was supposedly split three ways, but my sons share was used to pay their loans.   My questions is why should he, my son, have to pay taxes on monies he never received?
Submitted: 8 years ago.
Category: Tax
Expert:  Ed Johnson replied 8 years ago.

Dear PAJ,


Without knowing the details of the partnership agreement, all I can do is give you the general rule for this issue.


Many people refer to this a phantom tax or phantom income.


This is an issue of constructive receipt.


The IRS determines that if your son constructively received taxable income, then it is considered income and taxable, even if he did not actually receive the money.


This issue shows up MOST OFTEN, when a person receives a check for services rendered close to the end of the year, but it can not be cashed or is not received in the mail box before the new year.


This also happens when a parent wants a child to receive his pay, he assigns the pay. The IRS considers the pay constructively received by the partner.


IN this case, a partnership LLC, the distributions of earnings when to the partners, but was diverted to pay debt. This means the money was constructively received by your son, and has to be paid.


Now, you imply the debt was not your son's debt. That is another matter. That is an issue related to the partnership agreement. If your son's portion of earnings were used to pay personal loans of the other partners, then your son may have a cause of action to take up in court.


From the tax perspective, the money was constructively received and is there for taxable.



FYI: if this LLC did not make an S-election, the partners should not be paid on W-2. The partners are required to take their salary as a draw on revenues. If they have not taken an S election then they would pay MC and SS through self employment tax, using information from the K-1 on a schedule E and SE tax using form 1040-SE.

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