What Is Phantom Income?
Phantom income is typically an investment gain that has not yet been received but still creates a tax liability for a partnership or an individual. Phantom income is also sometimes referred to as "phantom revenue."
Business income may not be distributed but reinvested into operations. The partners or owners are still liable to pay the applicable income tax. Phantom income can apply to limited partnerships, debt forgiveness, zero-coupon bonds, S corporations or limited liability corporations (LLC), and real estate investing.
Key Takeaways
- Phantom income is typically an investment gain that has not yet been realized through a cash sale or a distribution.
- Phantom income creates a tax liability.
- Small businesses or partnerships should consult a tax professional to ensure cash distributions cover each owner's tax burden.
Taxation
Phantom income can occur when an individual is taxed on the value of their stake in a partnership even if they do not receive any cash benefits or compensation. For joint owners of small businesses structured as partnerships or LLCs, income may be reported to the Internal Revenue Service (IRS) on Schedule K-1 (Form 1065), but not received by the participants. If the reported income is significant, a partner may have to pay tax on the amount of the reported income.
For example, if a partnership reports $100,000 in income for a fiscal year–and a partner has a 10% share in the partnership–that individual's tax burden will be based on the $10,000 in profit reported. The sum may not be paid to the partner and rolled over into retained earnings or reinvested in the business, but the partner may still owe tax on the $10,000.
The same principle applies to individuals who contribute their labor to a startup in exchange for a stake in the partnership; even though they will not receive any cash compensation, they may still be liable for taxes on any profits the partnership reports.
Individuals should consult a tax professional to ensure that their cash distributions cover their tax burden, that a company pays the taxes on undistributed phantom income, or the tax burden is spread over a longer period.
Types of Income
Since zero-coupon bonds pay no interest until they mature, their prices fluctuate more than normal bonds in the secondary market. And even though zero-coupon bonds make no payments until maturity, their holders may be liable for local, state, and federal taxes on the amount of their imputed interest. This phantom income can be offset by purchasing tax-free zero-coupon bonds, tax-advantaged municipal zero-coupon bonds, or zero-coupon bonds.
Another form of phantom income can result from the cancellation of debt. Essentially, the creditor pays the delinquent borrower the amount of the debt forgiven. Creditors send taxpayers Form 1099-C, which shows the amount of "income" received in the form of forgiven debt. Taxpayers can complete IRS Form 982 to reduce taxes on their forgiven debt.
Some real estate investing practices can create phantom income where taxable income may exceed the proceeds of a property sale because of previous deductions. Phantom income in real estate is often triggered by the process of depreciation, whereby owners decrease the value of a property over time to offset their rental income.
What Is a Tax Distribution Clause?
A tax distribution clause can be included in a partnership's or LLC's business operating agreement. A tax distribution clause requires the business to make distributions to cover the member’s tax liability from allocated income. It ensures members receive enough cash from the LLC to cover any tax liability.
How Can Companies Prepare for Phantom Income Tax?
Companies should employ a tax professional to plan for phantom income tax. However, one idea for a partnership means allocating a certain percentage so that all members are covered for tax liability. A flat rate of perhaps 40% of taxable income ensures that each member will have that amount to cover their tax bill.
Is Non-Cash Compensation Considered Phantom Income?
Non-cash compensation can be a company car or other perks. These benefits are taxable even though the employee has not received cash and the value will be included in an employee's income.
The Bottom Line
Phantom income is a gain that has not yet been realized through a cash sale or a distribution and is taxable nonetheless. Small businesses and partnerships can plan to ensure cash distributions cover members' tax burdens by implementing a tax distribution clause in their operating agreements.
