Long after Halloween passes, many taxpayers across the country will continue to be haunted by the curious faces of phantom income. For some, there is hope; a CPA can often curtail, mitigate, or at the very least prepare a taxpayer for the trauma associated with paying tax on income that was never 'cash in hand.' For others, taxes will never be the same...
For cash-basis taxpayers, ‘Phantom Income’—aka the ‘Tax Bogeyman’, aka the ‘Green Reaper’, aka the ‘Phantom of the IRS’—is a spooky phenomena of the tax code in which there is taxable income, but not cash.
For individuals, phantom income is most notoriously associated with ownership interests in partnerships and s-corporations. The following circumstances are often suspect:
• K-1 income without corresponding K-1 distributions. If you have an interest in a 'pass-through' entity such as a partnership, s-corporation, or certain types of trusts, the income from that entity is taxable to you as the income is earned, not as the income is distributed or made available to you. Perhaps the business reinvested profits into property and equipment (generating a tax deduction in a future year). Perhaps the business is over-leveraged and must exhaust all cash reserves on debt repayments. Perhaps the business defaulted on its creditors and now must recognize income from cancellation of indebtedness. Yet another culprit may be a competitive compensation arrangement among members that creates a carryover of phantom income year after year.
*An ounce of prevention is worth a pound of cure.* For the visionary taxpayer, a company agreement will stipulate that minimum distributions of cash are to be made in the event of phantom income allocations. For the visionary and competitive taxpayer, a CPA will work with your bookkeeper on a monthly or quarterly basis to calculate, evaluate, and forecast phantom income in order to better manage compensation, earnings, and cash flow.
• 'Sweat equity' arrangements. If one member contributes $100,000 to a business for a 50 percent interest, while a second member contributes services and personal intangibles for the other 50 percent, then the second member is potentially at risk of being taxed on $100,000 of phantom income, because that member is being compensated for their services with a 50 percent interest worth $100,000. (For perspective, consider a Fortune 500 executive receiving $100,000 worth of company stock as part of a compensation package. This is a taxable event.) While there are many permutations of phantom income in the realm of deferred compensation and equity arrangements--including several 'ghoul'd ones which are beyond the scope of this posting--the most common for members of pass-through entities involve the contribution of services for partnership interests. Depending on the details, safe harbor from the IRS and/or an '83(b) election' may be available to avoid phantom income.
*An ounce of prevention is worth a pound of cure.* As the sweat equity partner, you can choose to contribute $100,000 for the 50% interest in the form of a promissory note to be paid off with your 50% of the company's future profits. Alternatively, the other member can choose to treat their $100,000 contribution as a short-term loan or convertible debt, and each member can then contribute a much smaller (but equal) amount--say $50--for their 50 percent interest. A well-versed business attorney will be able to document the details.
Less notorious, yet noteworthy forms of phantom income include zero-coupon bonds (boo-ring), debt forgiveness (unless you're insolvent), life insurance (lapse or surrender), and good ole Ponzi-style investment schemes...among others!
If you have concerns about phantom income this year, schedule a meeting with your CPA before January to prepare and if possible, be proactive.