Serving business owners since 2007“Phantom income,” or phantom revenue, often comes as an unpleasant surprise for business owners who have hastily chosen a business entity with pass-through tax treatment.
To illustrate, let’s say the business has profits that are taxable to its owners and, for some reason, chooses to retain those profits rather than distribute them to the owners. Owners must pay income taxes on this “phantom income,” which they have not actually received.
How does pass-through income work?
When a business makes money, it can decide to keep or share it. In pass-through companies, the money goes directly to the owners and shareholders—the people who receive the cash report this income on their tax returns.
A company creates phantom income if it invests its earnings into the business. Business owners can do this to grow and expand the business, improve products or services, increase the company’s value, or pay off company debt. This phantom income requires the company’s owners to pay taxes on the amount invested in the company despite not getting any cash in return.
Depending on a company’s business structure, pass-through taxes might be treated differently. Since corporate tax rates are typically lower than an individual’s tax rates and a corporation’s retained profits aren’t subject to double taxation as dividends, there are frequent situations where being taxed as a corporation is preferable to pass-through tax treatment.
What are some examples of phantom income?
There are many different ways to generate phantom income, all of which are susceptible to phantom taxation.
Here are some of the most common sources of phantom income:
- Investments: Investing in a company can lead to phantom income. If the company does well and makes a profit, it could reinvest the money to expand the business. Investors do not get any cash from the reinvestment, but they still have to pay taxes on their share of the profit.
- Real estate: Owning real estate generates phantom income if the property’s value increases. Even if the property owner does not sell the property or get extra cash, they might owe taxes on the increased value.
- Stocks: Similar to real estate, if the value of a stock increases, a stockholder could be required to pay extra taxes without getting cash in return. This additional tax also applies to stockholders who do not sell their stock.
- Loans: If a business owner lends money to someone who then pays the business owner back with something other than cash, this is considered taxable income. For example, if someone provides goods or services instead of money, it is treated like received income. The business owner must pay taxes on that income despite not getting cash.
- Debt cancellation: If a business owner owes a cash debt and the lender forgives it, they treat it as income. The business owner does not get cash, but because they no longer owe the money, they have to pay taxes on the forgiven debt.
How do I avoid phantom income?
Dealing with phantom income can be tricky, but there are ways to handle it.
Here are some tips to avoid being surprised by phantom income:
Tip 1: Plan ahead
Think about your investments and how they might create phantom income. If you have any assets that can increase in value, debt that a lender might cancel, or loans that you can repay in something other than cash, you can plan for it by setting aside money to pay phantom taxes.
Tip 2: Talk to an expert
Because tax rules can be hard to understand, it is essential to consult a tax professional. They can explain how phantom income works, help you plan for future phantom tax expenses, and assist you with finding ways to lower your tax bill.
Tip 3: Choose suitable investments
Some investments are more likely to create phantom income—for example, specific stocks and real estate types. You can choose investments that pay you cash instead. This way, you will not have to pay any investment-based phantom income taxes.
Tip 4: Monitor investments, property, and stock values
Keeping track of the value of investments, property, or stock shares can help a business owner prepare for phantom income taxes. If those values rise, they can prepare for a phantom tax bill.
Phantom income can be tricky and confusing. But understanding what it is can help you manage your finances better. By planning, talking to experts, choosing suitable investments, and monitoring any owned asset values, you can avoid any tax problems. Remember these tips and stay aware of how phantom income might affect you.
Before determining the best business entity to incorporate, contact a tax expert to help you consider the many complex tax questions. Once you know which business structure works best for you, MaxFilings can assist you with the incorporation process.
