Phantom Income in a Divorce in Arizona: Understanding the Concept

Thu 4th May, 2023 Arizona Divorce Laws

Divorce is a complex and emotional process that requires individuals to deal with various financial and legal issues, including property division, spousal support, and child custody.

One of the most challenging aspects of divorce is determining the income of each spouse, which can significantly impact the final settlement amount.

However, in some cases, divorcing couples may face a confusing and often overlooked concept known as phantom income.

In this article, we will explore what phantom income is, how it can impact a divorce settlement in Arizona, and what steps you can take to protect yourself.

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Understanding Phantom Income in an Arizona Divorce

Phantom income is a term used to describe income that is not actually received in cash or physical assets but is still subject to taxation.

Phantom income is income that is taxable but not yet received by the person being attributed the phantom income.

For example, let’s say a spouse owns a pass though income business, like a subchapter S corporation. Let’s also assume the spouse receives a salary of $100,000.00 from the business as a salary and that the revenue of the company was $150,000.00 more than the company’s expenses resulting in net profit of $150,000.00.

Let’s also assume the spouse who owns that company leaves that net profit in the business such that he never personally received that $150,000.00 because, for example, that additional income is needed by the business to purchase capital assets set as new equipment, vehicles, computers and the like, or is needed as working capital, or is needed by the company to pay for future growth of the company.

How Phantom Income Can Affect a Divorce in Arizona

How Phantom Income Impacts a Divorce in Arizona.

As you can see, the concept of phantom income in an Arizona divorce can pose some serious problems in the above example because the business owning spouse will only want his $100,000.00 salary to be considered for issues such as spousal maintenance and child support while the other spouse will want to include the additional phantom income and argue the other spouse earns $250,000.00 a year for purposes of spousal maintenance and child support.

As another example, the net income of the business may be decreased by expenses that were not incurred in the year in which the expense is reported, such as depreciation expense, which arguably artificially decreases the net income being that a spouse receives from his or her business.

Phantom income, therefore, can have a significant impact on a divorce settlement, primarily when dealing with assets such as businesses, investment properties, and stocks.

As you can see, the concept of phantom income can have a significant impact on a spouse’s ability to pay spousal support or child support, which can have lasting effects on the financial stability of that spouse for years.

Dividing Phantom Income as Community Property

In Arizona, property division follows the principle of community property laws, which states that all assets acquired during the marriage are marital property and subject to equal distribution. As such, any phantom income generated by marital assets may also be subject to division.

However, the calculation of phantom income can be complex.

How to Protect Yourself from Phantom Income in a Divorce

If you are going through a divorce in Arizona and are concerned about phantom income, there are steps you can take to protect yourself.

First and foremost, it is essential to work with an experienced divorce attorney who understands the concept of phantom income, who can identify it, and who can help you navigate the complexities of property division, spousal support, and child support.

It is also crucial to have a clear understanding of the assets involved in the divorce and any potential phantom income associated with those assets. This may require the assistance of a financial expert, such as a forensic accountant or a business valuation expert, who can help identify any hidden sources of income or explain why the phantom income should not or cannot be paid to the business owning spouse.

Finally, it may be necessary to negotiate a settlement agreement that accounts for phantom income and its potential impact on the divorce settlement. This may involve negotiating spousal support payments, property division, or other financial arrangements that adequately address the phantom income issue.

Conclusion

Divorce is a challenging process that requires individuals to deal with a wide range of financial and legal issues.

Phantom income is a concept that is often overlooked but can have a significant impact on a divorce settlement in Arizona.

Understanding what phantom income is and, more importantly, having a divorce attorney who knows what phantom income is and how to properly address it, can have a huge impact on the outcome of your divorce.

If you are facing a divorce and need assistance navigating the complexities of property division and spousal support, contact a qualified divorce attorney today. With the right legal guidance, you can ensure that your rights are protected and that you receive a fair settlement that properly addresses the issue of phantom income.

FAQ: Phantom Income in an Arizona Divorce

What is phantom income in an Arizona divorce?

Phantom income refers to taxable income that a person is legally required to report but has not actually received as cash. In Arizona divorce cases, phantom income often arises when a business owner earns profits through a pass-through entity, such as an S corporation, but leaves those profits inside the business instead of distributing them personally.

Why is phantom income important in an Arizona divorce?

Phantom income can significantly affect financial issues in a divorce, including spousal maintenance, child support, and property division. One spouse may argue that retained business earnings should be counted as available income, while the business-owning spouse may contend that those funds are necessary for business operations and are not available for personal use.

How does phantom income occur in a business?

Phantom income commonly occurs when a business generates profits that are allocated to the owner for tax purposes but remain inside the company. These retained earnings may be used for business growth, equipment purchases, working capital, or future expansion rather than being distributed to the owner.

Can phantom income affect child support calculations in Arizona?

Yes. A dispute may arise over whether retained business earnings should be included when calculating a spouse’s income for child support purposes. If phantom income is considered available income, it could increase child support obligations.

Can phantom income impact spousal maintenance awards?

Yes. Courts and attorneys often examine whether phantom income should be included when determining a spouse’s earning capacity and ability to pay spousal maintenance. The treatment of retained earnings can substantially influence support calculations.

Is phantom income considered community property in Arizona?

Potentially. Arizona is a community property state, meaning assets acquired during the marriage are generally subject to equitable division. If phantom income is generated from marital assets or a community-owned business interest, it may become relevant during property division discussions.

What types of assets commonly generate phantom income during divorce?

Phantom income is frequently associated with closely held businesses, pass-through entities, investment properties, partnerships, and certain stock investments. These assets may generate taxable income without providing immediate cash distributions.

How can depreciation affect phantom income in a divorce case?

Depreciation may reduce a business’s reported taxable income even though it does not represent an actual cash expense in the current year. This can create disagreements about a business owner’s true income and financial resources during divorce proceedings.

How do Arizona courts determine whether phantom income should be counted as income?

The answer depends on the specific facts of the case. Courts may examine the business structure, the reason profits were retained, whether funds are available for distribution, and the overall financial circumstances of the parties involved.

How can I protect myself from phantom income issues during an Arizona divorce?

Working with an experienced Arizona divorce attorney and qualified financial professionals can help identify phantom income and determine its impact on your case. Careful analysis of business records, tax returns, and financial statements is often necessary.

Should I hire a forensic accountant if phantom income is involved?

In many cases, yes. A forensic accountant or business valuation expert can analyze financial records, identify retained earnings, evaluate business expenses, and provide expert opinions regarding whether phantom income should be considered available income.

Can phantom income affect divorce settlement negotiations?

Absolutely. Phantom income can influence negotiations regarding property division, child support, and spousal maintenance. A settlement agreement may need to address how retained earnings and future business profits will be treated.

What is an example of phantom income in divorce?

A common example occurs when a spouse owns an S corporation, receives a salary from the business, and leaves additional profits in the company for future operations. Although those profits are taxed to the owner, the owner may never receive the funds personally, creating a phantom income issue.

Why is legal guidance important when phantom income is involved?

Phantom income can be difficult to identify and evaluate. Experienced divorce attorneys and financial experts can help ensure that business earnings, tax obligations, and support calculations are properly analyzed so that the final divorce outcome is fair and supported by accurate financial information.

Can phantom income increase a spouse’s financial obligations after divorce?

Yes. If phantom income is included in income calculations, it may increase obligations related to child support or spousal maintenance, potentially affecting a spouse’s financial situation for years after the divorce is finalized.

Our family law firm has earned numerous awards such as US News and World Reports Best Arizona Family Law Firm, US News and World Report Best Divorce Attorneys, “Best of the Valley” by Arizona Foothills readers, and “Best Arizona Divorce Law Firms” by North Scottsdale Magazine.

Call us today at (480)305-8300 or reach out to us through our appointment scheduling form to schedule your personalized consultation and turn your Arizona alimony or spousal maintenance case around.

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