Phantom Income: Definition & Risks

KEY TAKEAWAYS

• Phantom income is frequently an investment gain that has not yet been distributed or sold for cash.
• Phantom income, which is revenue that is ascribed to one’s tax burden even though it has not been realized. It can make tax planning more difficult.
• A tax professional should be consulted by parties who are joint owners of a small firm to help ensure that either their cash distributions will meet their tax burden. Or that the company will pay the taxes on undistributed phantom income.

What Is Phantom Income?

Phantom income occurs when some type of financial gain hasn’t been paid out yet but one is responsible for paying taxes on it. It often arises from investment gains that haven’t been sold or distributed to the investor.

Phantom income can also occur in any number of business types and situations. These can include debt forgiveness, certain benefits, and owners of limited liability corporations (LLCs) or S corporations, for example. 

Phantom income can create tax liabilities and complicate your tax processes and planning, because you will need to pay taxes on money that you haven’t received yet.

How Phantom Income Works

In a partnership or a S Corporation, one is taxed based on the net income of the company. You will be taxed on your share of the income regardless of the amount that has been paid out to you. if you’re not prepared, it can cause an unwanted tax burden. 

Let’s say that you have a stake in a partnership that reports $50,000 in income for the fiscal year. Your total shares are worth 10%, which means you would have a tax burden on $5,000 in the reported profit. Even if you decide to leave the profit in the company you might still be required to pay tax on the $5,000 although you didn’t take a payout.

Problems of Phantom Income 

The problem with phantom income happens between the net income allocation to owners and the actual cash distribution. The net income allocation for each of the partners or shareholders is reported on schedule K-1 of the business tax return, which each person is required to report on their individual tax returns.

This is where the problem usually occurs. The income has been allocated to a person, but more often than not, no actual cash or not all of the allocated amount has been paid out. In those situations phantom income can cause problems for you if you are not prepared to pay all the taxes.

How Do You Avoid Phantom Income? 

The good news is that there are several things that you can do to help avoid the possible tax complications of phantom income. It’s important to take the proper steps to plan for phantom income so you’re prepared.

Regularly conducting due diligence and examining financial statements can help provide insights into the potential of having to pay tax on an amount in excess of what was paid to you in the form of a distribution. You can forecast whether or not your business will generate net income, compare the amount that has been paid to you and plan accordingly for any additional amount of net income that you will need to include on your individual tax return. You will then be able to plan for another distribution to cover the increased tax payment.

Example of Phantom Income

Jim has a fifty percent ownership of an LLC with his partner Jennifer. The business did well the previous year and makes a profit of $20,000. Since it’s still early in the life of the LLC, both Jim and Jennifer decide they won’t want to withdraw any funds, but rather reinvest the profits to help the business grow. 

The LLC they own together is considered to be a pass-through tax entity. This means that Jim and Jennifer will both still have to pay taxes on their $10,000 net income, even though it was reinvested. They will include the $10,000 on their individual tax returns and pay taxes on the additional amounts. The amount that is reinvested in the company will be added to each of the owners’ bases.

This can help reduce future tax burdens should either Jim or Jennifer decide to sell their equity stakes. They also won’t have to pay tax for a second time once the profits are actually distributed to cash.

Summary 

Phantom income can sometimes get referred to as phantom revenue. It refers to any income or financial gain an individual hasn’t received but is still subject to taxes. Phantom income doesn’t happen too often, but if you’re not prepared for it to happen it can cause unintended tax complications. 

The biggest problem with phantom income occurs when an owner decides to reinvest their profits into the business. Since no actual cash is paid out, it can sometimes be confusing to still have to pay taxes. The best thing you can do is prepare for the possibilities so you’re not caught off guard.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.