A lot of taxes fly under the radar and go unreported. In 2021 alone, the IRS estimated that Americans didn’t pay approximately $688 billion in taxes.
The thing is, taxes have always been tricky and not as simple as jotting down your yearly revenue. You can be taxed on things that don’t have a liquid value. And one of those things is often lurking in your investments: phantom income.
What is phantom income, and what should you know about it for the coming tax season? Let’s take a look at this form of tax liability and how it affects you.
What Is Phantom Income?
Phantom income may sound like some unanticipated revenue, or perhaps even an illegal revenue stream you keep off the books. In reality, this is an investment gain that hasn’t yet reached its full potential via distribution and/or sale. To put it simply, it’s an investment “in embryo” that has yet to come to become a monetary benefit.
As you likely know from your tax planning, you have to report all of your finances. Even finances that don’t directly contribute to the taxes that you pay. For example, reporting on your income abroad even if it falls under the $100,000 taxation limit.
As a result, it creates a tax complication that you need to account for. The inclusion of the word “income” is what leads to confusion. Phantom is meant to indicate that it’s not entirely corporeal, i.e. it’s not on the books and clear like “real” income.
Whether or not you pay taxes on phantom income will depend on what type of revenue stream it is.
Phantom Income Example
So what does phantom income look like in practice? Here are a few common examples:
- Shares in limited partnerships
- Non-married partner benefits
- Forgiveness for your debts
- Certain types of bonds
- S-corporation ownership stake
- LLC involvement
You may have realized already that phantom income is sort of a catch-all term for a wide variety of investments. You may be liable for phantom income if you so much as claim a partner’s healthcare benefits. It can even include things like depreciation with a property in real estate.
So whether you’ve got an original issue discount bond or a bungalow in LA, it’s worth understanding how you are liable.
Does Labor Count?
A common term in startups is “sweat equity.” Put simply, this is when a person contributes labor to the company in building it up. In exchange for their efforts, they get equity in the company’s partnership.
Those who engage in sweat equity don’t immediately receive financial contributions for it. Still, they are liable for any related taxes on income that the partnership reports. In other words, somebody with sweat equity pays the same taxes as their partners despite not receiving compensation – at least, not yet.
Phantom Income and Debt
Debt cancelation can also lead to instances of phantom income. This is because your creditor “pays” you – the “delinquent” borrower – and thus cancels out your debt. After they do this, they send you Form 1099-C, the reported “income” of forgiven debt.
Despite having your debt forgiven, you’d still be liable to a degree. The IRS would expect you to fill out Form 982.
Taxation vs Compensation
A common question people have about phantom income is whether they can be taxed regardless of compensation. That is, can the Fed tax them when their phantom income source does not provide them any actual dividends or revenue?
Suppose, for example, you have an LLC that has some value but does not (for a certain tax year) put any money in your bank. Even if you don’t receive a single cent from this LLC, it could still create a tax burden. The Fed would expect you to pay taxes on the value of your stake – or some equivalent agreement on its value.
Situations can occur where a small business reports Schedule K-1 income, which you likely don’t receive. Then the IRS will expect a payment based on that reported income. That includes when you got none of it!
This is why it poses a challenge to have phantom income if you don’t take the time to plan for it. There will likely be some degree of tax burden. Anticipating it ahead of time with a professional tax planner is key to avoiding a sudden audit or scary letter from the IRS.
Mock Examples
So, let’s go back to the example of the LLC. Suppose your LLC pulls in $100,000 worth of revenue for the partners. Now, imagine that your stake in the company is a 10% share.
As is common, business owners will take their earned profits and reinvest them in the company. This is the case with billionaires like Jeff Bezos, with whom most of their estimated net worth is stock in their own company. So, imagine you take that 10% share’s worth of income – $10,000 dollars – and reinvest it or roll it over for retained earnings.
Remarkably, you would still be liable for the tax on that $10,000 share income. It doesn’t matter if you don’t have the money in your bank account. The IRS will still expect their slice.
The same could happen in another theoretical example where you sell off your share to exit the partnership. This still counts as profit in the eyes of the IRS. Thus, you’d still be liable.
How to Handle Phantom Income
Having read this article, it may seem like phantom income is everywhere. You don’t necessarily need to be a business owner or real estate mogul. After all, you could be liable for phantom income just by having your student loans forgiven!
The key, as always, is to hire a professional tax preparer. People with atypical tax situations usually get a CPA to look over their books and make sure all their ducks are in a row. This is a miserly sum when compared to the money you could stand to lose in taxation and penalties.
Prepare Your Taxes Today
What is phantom income? It’s a fairly straightforward term that applies to a wide variety of unrealized investment gains, from equity to real estate ownership. Despite reaping no monetary benefit in your bank account, you must account for it if you are liable.
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