Phantom Income: What It Is and How It's Taxed

What Is Phantom Income?

Phantom income is typically an investment gain not yet received, but which still creates a tax liability for a partnership or an individual.

The businesses and financial situations where phantom income occurs include debt forgiveness, limited liability companies (LLCs), limited partnerships (LPs), real estate investing, S corporations, and zero-coupon bonds.

Phantom income, which is also sometimes referred to as phantom revenue, creates a tax burden even if actual cash is not received. It can be reported on IRS Schedule K-1 but not paid out to participants.

Businesses and individuals should consult tax professionals to manage or offset their tax liabilities from phantom income.

Understanding the Tax Implications of Phantom Income

Phantom income occurs when someone is taxed on their partnership share's value without receiving cash benefits or compensation. For joint owners of small businesses structured as partnerships or LLCs, income may be reported to the Internal Revenue Service (IRS) on Schedule K-1 (Form 1065), but not received by the participants. If the reported income is significant, a partner may have to pay tax on the amount of the reported income.

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. The sum may not be paid to the partner and rolled over into retained earnings or reinvested in the business, but the partner may still owe tax on the $10,000.

This also applies to those who work for a startup in return for a partnership share. They may owe taxes on reported profits, even without cash compensation.

Different Forms of Phantom Income

Zero-coupon bonds don’t pay interest until maturity, so their prices can fluctuate more than regular bonds. Despite no payments until maturity, holders may owe taxes on the imputed interest at local, state, and federal levels. This phantom income can be offset by purchasing tax-free zero-coupon bonds, tax-advantaged municipal zero-coupon bonds, or zero-coupon bonds.

Another form of phantom income can result from the cancellation of debt. The creditor forgives the debt, essentially paying that amount to the borrower. Creditors send taxpayers Form 1099-C, which shows the amount of "income" received in the form of forgiven debt. Taxpayers can complete IRS Form 982 to reduce taxes on their forgiven debt.

Some real estate investing practices can create phantom income where 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 to offset their rental income.

The Bottom Line

Phantom income is a taxable investment gain not accompanied by an actual cash receipt (such as a sale or distribution). It typically affects limited partnerships, LLCs, and individuals, among others.

A tax professional should be consulted to adequately prepare for the tax liabilities created by phantom income. Businesses—particularly LLCs, partnerships, and small businesses—should consider implementing a tax distribution clause to address tax burdens arising from phantom income.

Different phantom income scenarios and their tax burdens include debt cancellation (taxpayers receive Form 1099-C showing forgiven debt "income" and complete Form 982 to reduce taxes), noncash compensation (taxable work benefits even though the employee has not received cash), and zero-coupon bonds (holders may owe taxes on the imputed interest).

Proactive planning, such as the aforementioned tax distribution clause, ensures cash distributions can cover tax liabilities for members of businesses and partnerships and avoid financial strain.