What is Phantom Income
Phantom income is money that is never received by a partnership or individual but is still taxable. Also referred to as "phantom revenue," overall, phantom income is not terribly common, but does complicate the tax planning of participants in limited partnerships. It can also apply to medical benefits for non-married partners, debt forgiveness, zero-coupon bonds, owners of S corporations or limited liability corporations (LLC), real estate investing and a few other circumstances. In each case, an individual may not receive any cash benefits or compensation but will be taxed on the value of their consideration nonetheless.
Breaking Down Phantom Income
Phantom income can take many forms and can create unexpected tax burdens if not planned for. It is likely most problematic in partnerships and LLCs. Some joint owners in small businesses can run into issues with phantom income when income is reported to the Internal Revenue Service (IRS) in Schedule K-1 (Form 1065) but is not actually received. If the reported income is significant, the partner will have to pay tax on it even without having received any cash.
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 $10,000 in profit reported. Yet, if that sum is not paid to the partner, such as if it is rolled over into retained earnings or otherwise reinvested in the business, the partner still owes tax on the full $10,000. Similarly, if a partner is bought out early in the year but a Schedule K-1 report shows a profit to the IRS, that partner would still be liable for their share even though they no longer own it or have any right to the partnership's profits.
The same principle applies to individuals who contribute their labor (sweat equity) to a startup in exchange for a stake in the partnership; they will receive no cash compensation yet will have to pay tax on any profits the partnership reports. In such cases, partners should consult with tax professionals to ensure that their cash distributions cover their tax burden, that the company pays the taxes on undistributed phantom income or that the burden is spread over a longer period.
Phantom Income: More Examples
Since zero-coupon bonds pay no interest until they mature, their prices fluctuate more than normal bonds in the secondary market. And despite the fact that they make no payments until maturity, holders may be liable for local, state and federal taxes on them on their imputed interest, or phantom income. This can be offset by also buying tax-free zero-coupon bonds or tax-advantaged municipal zero-coupon bonds.
Cancellation of debt is another form of phantom income. The creditor essentially "pays" the delinquent borrower the amount of debt forgiven, which is why creditors send Form 1099-C to the borrow showing the amount of "income" that he or she received as forgiven debt. IRS Form 982 can be filed to reduce taxes on forgiven debt.
Phantom income can happen in domestic partnerships in which an individual is taxed for medical benefits they receive via their partner's employer healthcare coverage.
Some real estate investing practices may create phantom income, such as when taxable income exceeds the sales proceeds of a property at its sale due to previous deductions. Phantom income in real estate is often triggered by depreciation, which allows owners to decrease the value of a property over time to offset rental income.