What Is Phantom Income?

Phantom income is typically an investment gain that has not yet been realized through a cash sale or a distribution. However, it still creates a tax liability for a partnership or an individual. Phantom income is also sometimes referred to as "phantom revenue." While phantom income is not necessarily a common occurrence, it can complicate the process of tax planning when it does occur.

Phantom income can apply in instances of limited partnerships, benefits for non-married partners, debt forgiveness, zero-coupon bonds, owners of S corporations or limited liability corporations (LLC), and real estate investing, among other scenarios.

Key Takeaways

  • Phantom income is typically an investment gain that has not yet been realized through a cash sale or a distribution.
  • Phantom income can complicate the process of tax planning because, even though it has not been realized, it is income that is attributed to one's tax liability.
  • In the instance of joint owners of small businesses (structured as partnerships or limited liability corporations (LLCs)), impacted parties should consult with the services of a tax professional to help ensure that either their cash distributions cover their tax burden or that that the company pays the taxes on undistributed phantom income; alternatively, they can attempt to spread their tax burden over a longer period of time.

How Phantom Income Works

Phantom income occurs when an individual is taxed on the value of their stake in a partnership (or another equivalent agreement), even if they do not receive any cash benefits or compensation. Phantom income can pose challenges for taxpayers when it is not planned for because it can create an unexpected tax burden. For joint owners of small businesses (structured as partnerships or LLCs), it can be especially problematic in a scenario where income is reported to the Internal Revenue Service (IRS) in Schedule K-1 (Form 1065), but the income is not actually received by the participants. If the reported income is significant, a partner may have to pay tax on the amount of the reported income (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 the $10,000 in profit reported. Even if that sum is not paid to the partner because, for example, is it is rolled over into retained earnings or reinvested in the business, the partner may still owe tax on the full $10,000. Similarly, if an individual is bought out or exits a partnership early in the year, but a Schedule K-1 for reports a profit to the IRS, that partner may 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 (or sweat equity) 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.

In these scenarios, it is recommended that the impacted parties consult with a tax professional. A tax professional will likely be able to help ensure that their cash distributions cover their tax burden, that the company pays the taxes on undistributed phantom income, or alternatively, that the tax burden is spread over a longer period.

Examples of Phantom Income

Since zero-coupon bonds pay no interest until they mature, their prices tend to 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 to the amount of their imputed interest. This type of phantom income can be offset by purchasing tax-free zero-coupon bonds or tax-advantaged municipal zero-coupon bonds, in addition to 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 that is being forgiven; creditors send taxpayers Form 1099-C, which shows the amount of "income" that they received in the form of forgiven debt. Taxpayers have the option of filling out IRS Form 982 in order to reduce taxes on their forgiven debt.

Phantom income can also happen in domestic partnerships: an individual may be taxed for medical benefits they receive via their partner's employer-based healthcare coverage.

In addition, some real estate investing practices can create phantom income; sometimes, 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 in order to offset their rental income.