As contingency fee law firms prepare their tax returns, there are three key considerations for how attorneys can avoid the phantom income trap:

1. Do I understand how phantom income affects my law firm?
2. How paying for case disbursements with law firm revenue impacts phantom income.
3. How can I avoid the phantom income trap?

Whatever business structure your law firm operates under, calculating your taxable income can be a challenge. It is especially true for law firms that are “self-financed,” meaning law firms that operate without any commercial loans or lines of credit. These “self-financed” law firms have an opportunity to avoid the pitfalls of phantom income and a potentially burdensome tax bill.

What is phantom income?

Phantom income, also referred to as phantom revenue, occurs when a business owner pays taxes on income that has not been distributed to the business owner. Most often, the business uses this income to pay for operating costs. For trial lawyers, the income is often used to pay for case costs.

The issue trial lawyers face is compounded because these disbursements are typically not recouped by the time their taxes are due to the IRS. More importantly, the IRS does not consider case costs as deductible expenses. As a result, trial lawyers face significant tax burdens because they self-finance cases which may not settle for months or years.

For growing law firms, phantom income is seen as an even greater impediment and a limiting factor to growth. In particular, self-financed contingency law firms tie-up the fees from settled cases by funding current and future case costs. As a result, the lack of available capital to invest in marketing, technology, staffing, and other resources leads to stunted growth.

What are the pitfalls of self-financing?

How does your firm handle case disbursements? Many small contingency fee law firms are self-financed, using after-tax dollars earned from previous cases to pay for current case costs.

Operating as both lawyer and a lender not only places an unnecessary burden on your personal finances, but also makes your law firm vulnerable to phantom income. Moreover, it limits your firm in terms of growth because the capital that is tied up in case disbursements could otherwise be used for growth related initiatives.

For instance, self-financed firms are often unable to invest in the areas which can drive business growth like, hiring resources, marketing, technology, and improving operations. These limitations hinder law firm growth. As a result, self-financed firms are often restricted to a certain practice area, geographical market, or smaller presence in their existing market.

How Can I Avoid the Phantom Income Trap?

Case cost financing as a solution

Contingency fee law firms are capital-intensive businesses, and self-financed firms can easily fall into the phantom income pitfall while building-up a caseload. However, there are ways to remedy these challenges.

If you are operating a self-financed firm or financing through a traditional bank, case cost financing can help your law firm avoid being taxed on income which has not been distributed to the partners. Additionally, case cost financing provides an effective solution for growing your business. It enables law firms to run the day-to-day business, while also providing a separate credit facility to finance case disbursements. Having the financial flexibility to decide where to deploy capital is a key driver for growth and expansion as well.

The interest related to case cost financing is also tax deductible, reducing the law firm’s tax burden. Some firms choose to pass on the cost of the interest to their clients and it is advisable to put the language in your retainer agreements to allow for the option to do that. Before doing so, it is important for you to check your state’s ethics opinion.

Financial planning is essential

A significant consideration for avoiding the phantom income tax trap is how to plan your law firm’s finances for the long-term so cash flow and case flow are not pitted against each other, sacrificing the growth of the firm.

Assessing the value of your case inventory and projecting your future fees are essential steps. Placing estimates on the value and timing of your cases, and communicating your success rates to lenders, will help you obtain the best, case cost financing your firm needs. Esquire Bank takes a number of factors into account when assessing the value of a firm in addition to case inventory, including historical successes, the firm’s existing technology, the source of new cases and the law firm’s structure.

Looking for more information about phantom income?

Watch the 3-minute video to understand more about phantom income, featuring Bryan Koshers—Contingency Fee Accounting Specialist.

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Learn how your law firm can leverage case cost financing to free up capital that can be invested in marketing, technology, talent, operations, case acquisition, and scaling law firm growth. Schedule a no-obligation consultation with an Esquire Bank Business Development Officer today at a time convenient to your schedule.

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*The information provided on this blog is provided for general informational purposes only and is not intended as, and should not be relied on for, law firm operations, tax, legal or accounting advice. Some of the information may not be applicable or appropriate for all law firms. Please consult your own tax, legal and accounting advisors as appropriate.