Phantom income is a term that refers to income that is attributed to an individual or entity’s tax liability but without receiving cash to offset the tax liability. In other words, it is income that has yet to be realized (or formalized) through a cash sale or distribution but still creates a tax liability for the individual or entity. This phenomenon can occur in various situations, including investments, partnerships, and LLCs.
This article will refer only to American taxes, not multi-national or different countries.
One of the most common ways phantom income arises is through investments. For example, an individual may have invested in a stock that has increased in value but has yet to be sold, resulting in a paper gain. However, this paper gain still creates a tax liability for the investor, even though they have not received any cash from the investment. Similarly, partnerships and LLCs may report yearly profits, yet the owners or investors in the business do not accept cash reflecting the allocation, resulting in phantom income.
Avoiding phantom income requires careful planning and consideration. Partnerships and LLCs can draft tax distribution clauses in their operating agreements to protect against it. These rules ensure the business makes monetary distributions to cover members’ tax liability from allocated income. Awareness of situations where phantom income may arise and taking proactive steps can help avoid unexpected tax liabilities.
Key Takeaways:
- Phantom income refers to taxable income attributed to an individual or entity but not received in cash, resulting in a tax liability without cash to offset it.
- Common situations where phantom income arises include investments, partnerships, and LLCs.
- Partnerships and LLCs can include tax distribution clauses in their operating agreements to protect against phantom income, ensuring cash distributions to cover tax liabilities.
- Phantom income can also be a concern for investors in S-Corporations and C-Corporations.
- Being aware of situations where phantom income may arise and taking proactive steps can help avoid unexpected tax liabilities.
Understanding Phantom Income
Phantom income is a phrase used to describe taxable income that an individual is considered to have earned but has not actually received in cash. It is also known as “paper income” or “book income.” This section will explore the definition, causes, and examples of phantom income.
Definition
Phantom income is a type of income that is taxable but not actually received in cash. It can arise in various situations, such as when a partnership or other pass-through entity generates income but does not distribute it to its partners or members. In such cases, the partners or members are still taxed on their share of the income, even though they did not receive any cash distributions.
Causes
One of the leading causes of phantom income is the use of pass-through entities, such as partnerships, limited liability companies, and S corporations. These entities do not pay income tax at the entity level but instead pass through their income, deductions, and credits to their partners or members. This means that the partners or members are responsible for paying taxes on their share of the entity’s income, even if they did not receive any cash distributions.
Another cause of phantom income is using certain tax-deferred investment vehicles, such as individual retirement accounts (IRAs) and 401(k) plans. These accounts allow individuals to defer taxes on their contributions and earnings until they withdraw the funds. However, when the funds are removed for tax purposes, they are treated as ordinary income, even if, over that period, the taxpayer did not receive any cash distributions during the accumulation phase.
Examples
One example of phantom income is when a partner is given a share of the partnership’s business income but does not receive any cash distributions. In this case, the partner is still responsible for paying taxes on their share of the income, even though they did not receive any cash.
Another example of phantom income is when an individual invests in a tax-deferred investment vehicle, such as an IRA or 401(k) plan, and then withdraws the funds during retirement. Even if the individual did not receive any cash distributions during the accumulation phase, they would still be taxed as ordinary income on the total withdrawal amount.
It is vital for individuals to be aware of the potential for phantom income in their investments and to plan accordingly. This could involve setting aside funds to cover the tax liability associated with phantom income or choosing investments less likely to generate phantom income.
Phantom Income in Partnerships
Phantom income can be complicated for partnerships taxed as pass-through entities. Partnerships must file an annual tax return, but the partnership does not pay taxes on its income. Instead, each partner is allocated a portion of the partnership’s income, gains, losses, deductions, and credits on their tax return. This means that at tax time, every partner and business owner is responsible for paying their respective tax burdens on their portion of the partnership’s income, even if they do not receive any cash distributions.
Partnership Taxation
Partnerships are taxed differently than other types of businesses. They are not subject to federal income tax, but their partners are responsible for paying taxes on their share of the partnership’s income. Partnerships must file an annual tax return on Form 1065, which reports the partnership’s income, gains, losses, deductions, and credits.
Cash vs. Accrual Accounting
Partnerships can use either cash or accrual accounting to report their income. Cash accounting records income when it is received, while accrual accounting records income when it is earned. The IRS allows partnerships with less than $25 million in annual gross receipts to use cash accounting, but larger partnerships must use accrual accounting.
Distributions and Tax Liability
Partnerships can distribute their profits to their partners in several ways, including cash distributions, property distributions, and allocations of partnership income. Partners are taxed on their portion of their income, even if they do not receive any cash distributions. This can result in phantom income, where partners are taxed on income they have not received.
Partnerships can also have a tax liability for distributions made to partners. However, if the distribution exceeds the partner’s basis in their partnership interest, it is taxable and treated as a gain.
Partnerships should have a tax distribution clause in their operating agreement to ensure that partners know their tax liabilities and that the partnership can make distributions to cover those liabilities.
Overall, partnerships should carefully consider their tax planning and due diligence to avoid phantom income and other tax issues. Partnerships should consult with a financial or tax professional to ensure they correctly allocate income, reinvest profits, and manage their tax liabilities.
Phantom Income in Other Business Entities
S-Corps
Phantom income can be a problem for investors in S-Corporations, where the profits and losses of the business pass through to the shareholders’ tax returns. This means that shareholders may be taxed on income they did not receive in cash.
One way to avoid phantom income in S-Corps is to ensure that distributions are made to shareholders in proportion to their ownership interests, and this helps ensure that shareholders are only taxed on the income they receive.
LLCs
LLCs are another type of business entity that can experience phantom income. This occurs when the LLC reports a yearly profit, but the owners or investors in the business do not receive cash for the allocation.
To avoid phantom income in LLCs, it is vital to ensure that distributions are made to members in proportion to their ownership interests, and this helps ensure that members are only taxed on the income they receive.
C-Corps
C-Corps are not typically subject to phantom income because they are taxed as separate entities. However, shareholders may still experience phantom income if the corporation’s earnings are reinvested in the business rather than distributed as dividends.
One way to avoid phantom income in C-Corps is to ensure shareholders pay dividends in proportion to their ownership interests, which helps ensure that shareholders are only taxed on their income.
What About Robert Kiyosaki And Phantom Income
Recently, I was wracking my brain on what I could do for my money to work even more efficiently for me than it has been. You know, work smarter, not harder?
The problem is that, like you, I work a 9-5 and only have limited time to pull something like this off. It’s all on me and what I could figure out.
Luckily I have some partners and mentors I learn from, and I want to pass this on to you.
I was working on a straightforward deal that increased my cash flow out of thin air that you might want to hear about and take advantage of yourself.
It’s a technique that I learned about from my partners and Robert Kiyosaki when they talk about “Phantom Income.”
Kiyosaki says, “The phantom income from debt is the time and money you save renting money rather than working to earn it, paying taxes on it, and saving it.”
So what exactly does that mean?
It would be best to run you through a recent example of how I used this in my finances.
Recently I finished refinancing a group of properties that I own. Interest rates right now are at an all-time low, and I couldn’t pass up the chance to take advantage of them.
What did I do exactly?
I refinanced about $340k worth of debt into a much lower interest rate, and it did two things for me:
#1) I Lowered my monthly payment on that debt by roughly $200.
#2) I Pulled enough equity out of my assets to purchase two more properties, each of which will net me roughly $250 per month over the life of my owning them.
I’ll have increased my cash flow (which I’ve been talking about with my online family for a while) by roughly $700 monthly.
Not an enormous win, but as I keep hitting financial “singles” like this repeatedly, I keep increasing my monthly cash flow one step at a time.
The kicker? Between the phone calls and paperwork, it took me to set things up, I spent 5 hours total over a couple of months to pull this together, and I didn’t spend one single dime out of pocket to do so.
As Kiyosaki says, “Phantom Income.”
With this strategy, anyone with little equity can flip it and generate more cash flow for themselves.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.
