Phantom IncomeDefinition, Examples and Breakdown

Written By:
Adiste Mae

What is Phantom Income?

Phantom Income, sometimes called Phantom Revenue, is a type of income that business owners or investors will have to pay taxes on despite them not having received any cash, or are yet to receive the actual cash from the revenue.

Typically, income is recognized through a cash sale or distribution while phantom income is an unrealized profit.

Because Phantom Income has to be reported, it possesses a tax burden for business owners especially if the amount of income is considerable.

When this happens, a company may struggle to get the cash to pay the tax amount or worse, they might not be able to pay on time.

Phantom Income rarely happens but when it does, it can pose a complication of the tax planning process.

Imagine getting surprised with an additional tax liability for a profit you did not even receive the actual proceeds on yet.

How Phantom Income Works & What Triggers It?

Typically, Phantom Income occurs in business profits, business capitalization, debt forgiveness, zero coupon bonds, limited partnerships, S Corporations or Limited Liability Corporations (LLCs).

For corporations, the income earned is distributed among its stockholders as dividends.

In some cases, these profits in corporations are not distributed and stay with the corporation as retained earnings.

By law, the equity holder will still have to report their share of the income regardless of whether or not they have received the proceeds, and will have to consequently pay tax on it.

This triggers the creation of Phantom Income – the equity holder does not receive the actual cash from the income but will still have to pay for the corresponding taxes.

The same event happens in the case of small business owners of partnerships or LLCs who have a joint stake in the business.

When the income is reported to the Internal Revenue Service (IRS) but the profit is not yet distributed, a tax liability is also created.

So regardless of the partner actually receiving cash or not, a tax will have to be paid on the reported income.

Or in the case of a startup – when a professional performs work or labor in the business in exchange for an equity interest also called “sweat equity”, the individual will be charged for the value of their equity interest in the business at their ordinary individual tax rates for the profit that the partnership reports.

The Phantom Income in this case poses a problem for the individual because oftentimes, their equity interest in the business is not liquid.

This means tax will have to be paid even when that interest provides little to no means of liquidating that asset to pay for taxes.

An individual can approach tax professionals so that they can make the necessary arrangements to cover the tax burden with their cash distributions.

Examples of Phantom Income

Phantom Income can sometimes be a cause of nightmare to some people because when reporting a considerable amount of phantom income, it can also mean a considerable amount of tax burden.

To understand Phantom Income better, let us take a look at a few examples.

Suppose John owns 50% of ABC Company with Paul.

At the end of the financial year, the company made a profit and reported an income of $100,000.

If both owners decide to split the profits among themselves for $50,000 each, Phantom Income is not created.

However, should both owners decide not to pay themselves and keep the income in the company as retained earnings, both John and Peter will still be liable for the tax on the profit even if they did not receive the cash from their company.

Another example is a zero coupon bond.

Zero coupon bonds normally mature in ten, fifteen or more years and do not pay interest during the life of the bond.

Even though no interest is paid until its maturity, investors will still have to pay for federal, state and local income tax on the interest that accrues every year.

The income on the accrued interest is the phantom income.

What most investors do in the scenario is that they purchase municipal zero coupon bonds or corporate zero coupon bonds that have tax-exempt status to avoid paying tax on the imputed or phantom income.

Debt forgiveness or debt cancellation is a normal occurrence.

While an indebted person may feel relieved to have the burden of paying for their credit card debt or other debts off their shoulders, the amount of the debt forgiven is a taxable income and as such, creditors will send the taxpayer Form 1099-C that will show the amount of forgiven debt.

When the taxpayer is able to finally breathe freely for being debt-free, they are often surprised to know that another liability comes in the form of taxes.

In order for the tax on the forgiven debt to be reduced, the taxpayer can choose to fill out IRS Form 982.

In the case of real estate investments, Phantom Income comes in the form of depreciation, whereby the value of the property decreases over time in order to offset the rental income.

Where is Phantom Income Reported?

Phantom Income increases tax liability.

Even if you have not received actual cash on this kind of revenue, you will still have to report this to the IRS, specifically in schedule K-1 (Form 1065).

No matter how big or small the amount of phantom income is, taxpayers are required to pay taxes on them.

Phantom Income can cause a serious tax burden for investors and business owners.

The help of tax professionals may be required to help ensure that they will not be burdened by taxes from their phantom income.

Some precautionary measures that investors can take to avoid paying for additional taxes in the future can include a tax distribution clause in the case of partnership agreements, by-Laws and LLC operating agreements.

Or in case of the company buying your shares, investors can include a clause stating that the company will have to pay for the taxes on any undistributed profits.