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Phantom Income: What it Means, How it Works
Lea Uradu, J.D. is a Maryland State Registered Tax Preparer, State Certified Notary Public, Certified VITA Tax Preparer, IRS Annual Filing Season Program Participant, and Tax Writer.
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.
- 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.
Internal Revenue Service. " Partner's Instructions for Schedule K-1 (Form 1065) (2019) ." Accessed Jan. 15, 2020.
U.S. Securities and Exchange Commission. " Zero Coupon Bonds ." Accessed Jan. 15, 2020.
Internal Revenue Service. " Topic No. 431 Canceled Debt – Is It Taxable or Not? " Accessed Jan. 15, 2020.
The LGBT Bar. " Taxation of Domestic Partner Benefits ." Pages 1-2. Accessed Jan. 15, 2020.
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Beware of Phantom Income and the Tax It Brings
Several investments trigger this tax and investors should be prepared.
Beware Phantom Income and Its Tax
Investors can avoid phantom income tax by holding these types of securities in tax-favored accounts. (vitacopS/Getty Images)
Most investors understand how taxes apply to capital gains, dividends and interest. But those accustomed to mainstream assets like stocks, bonds and funds can be surprised when they get off the beaten path with Treasury inflation-protected securities, zero-coupon bonds, S corporations and other unfamiliar investments.
A key issue: tax on "phantom income," an investment gain that has not yet been realized through a sale or cash distribution. It can apply to the securities mentioned above, and to holdings in businesses that pass only some of their income to investors
"Phantom income is income that is attributed to one's tax liability, but without receiving the cash to offset the tax liability," says L. Burke Files, president of Financial Examinations & Evaluations in Tempe, Arizona.
[See: 7 Classic Inflation Hedges and Their Thorns .]
"For example, a partnership investment that generated a gain of $1 million on a land swap, but it is a paper gain and there is no distribution of cash. If you own 10 percent you now have to pay real tax on your $100,000 paper gain."
Various types of investments can trip up investors, but there are some strategies for minimizing the damage:
Treasury inflation-protected securities. TIPS are designed to protect the investor from inflation by increasing the principal every six months by the inflation rate. A $10,000 investment could therefore be revalued at $10,300 if inflation ran at 3 percent. Then the bond's yield, or interest rate, would be applied to the new principal, raising the interest income a tad.
That interest payment would be taxed as ordinary income if the bond were held in a taxable account, just like interest from an ordinary bond. And the $300 principal increase would be taxed as well, even though the investor would not pocket that money until the bond matured and all principal was returned. To add insult to injury, the principal increase is taxed as income rather than at the lower long-term capital gains rate that would apply to an ordinary bond held for more than a year and sold at a profit.
Zero-coupon bonds. These are a type of government or corporate bond that pay no interest. Instead, the investor buys the bond at a discount and then receives the full face value when the bond matures. These bonds appeal to investors who want a predictable payoff tied to a future need like retirement , and to those betting interest rates will fall, since prices in the secondary market can be very volatile. Falling rates make an older more-generous bond very attractive.
But, again, the investor must pay income tax on the bond's annual increase in value, even though no cash is received.
Other types. Phantom income can also be a problem for investors in S-corporations, partnerships and limited liability companies, says Parag P. Patel, a tax attorney with offices in New York, New Jersey and Florida.
[See: 11 Steps to Make a Million With Your 401(k) .]
"The entity reports to the IRS via the tax return and the corresponding K-1 [form] who the owners are and their corresponding assigned amounts of income," he says, noting that the income reported may be larger than the actual cash distributed to the investor if the business reinvests some income or holds it in reserve.
Avoiding annual tax. Investors can avoid phantom income tax by holding these types of securities in tax-favored accounts. In individual retirement accounts and 401(k)s there is no annual tax on either interest earnings or principal increases. Instead, withdrawals – generally after age 59½ – are taxed as income.
In Roth IRAs and 401(k)s, neither interest nor principal gains are ever taxed, even after withdrawal.
Ugly surprises can be avoided if one invests though a fund that makes regular distributions of principal increases as well as interest earnings, says Anish Ramachandran, senior vice president of investment management at Lido Advisors in Los Angeles.
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"This problem is not there if one invests in a TIPS fund or an ETF if they have monthly distribution that includes coupon income from the underlying TIPS and principal adjustment for inflation," he says. "In my view, that would be an easier way to access the TIPS market."
While the investor in TIPS or zero-coupon bonds may be stuck with phantom income, investors in S corporations and other businesses that could have this problem have various remedies, Files says.
"An example of a hedge [against] phantom income would be an offset by deductions such as depreciation or depletion allowance," he says. "It is common for oil and gas portfolios to hold zero coupon bonds whose maturity is tied to the end of the oil and gas partnership or the economic life of a given oil and gas field. The phantom income is offset by depletion allowances and depreciation.
"One will often hear statements such as the company took a one-time gain on assets or the company took a one-time write down on asserts. Sharp CFOs try and balance those one-time gains and one-time losses to occur on the year or quarter that is most advantageous."
The investor who gets off the beaten path of stocks, bonds and funds is wise to look into how the business will minimize phantom income, as it may be necessary to set aside other funds to pay tax.
[See: 7 Things You Need to Understand About Your 401(k) .]
"For tax purposes, one can declare, depreciate, defer, deduct," Files says. "It is unwise to dodge."
7 New Taxes Retirees Face
Tags: money , investing , income , income tax , taxes , 401(k)s , IRAs
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