Introduction
Business owners face many financial challenges, and one of the financial challenges confronted by business firms is Phantom Income. It means the money allocated to someone but not yet paid out.
Partners, managers, and people managing distributions must understand the phantom income. You also need to recognize the tax implications of your firm's distribution decisions so that you can be prepared for phantom income, and you can save from additional tax filing during tax season.
We discuss phantom income in more detail, characterizing what phantom income is and what commonly causes it in an expert administration firm, in this overview blog.
Also, we will know about how entrepreneurs, CFOs, and regulators can strategize for phantom income and avail benefits of phantom deductions.
Let’s Read!
What is Phantom Income?
Phantom income refers to profits from investments that haven't been received as cash or through a sale yet. It creates a tax risk for both individuals and businesses. Sometimes, it's called phantom revenue. While phantom income doesn't always occur, it can complicate tax planning when it does.
Limited partnerships, benefits for unmarried partners, debt forgiveness, zero-coupon bonds, owners of S corporations or LLCs, and real estate investments, among other cases, include Phantom Income.
For instance, if in a partnership, the firm distributes profits to partners regularly, and when a partner is allocated more income than they received in a year, then it is called Phantom income. So, here partners must pay taxes on the income allocated to them, rather than the cash they received. It leads to failure to manage phantom income properly and creates serious tax problems for partners.
Let’s understand exactly how phantom income works.
How does phantom income work?
As you know, phantom Income occurs when a person is taxed based on the value of their stake in a business or similar agreement, even if they do not receive any cash benefits or income.
This creates concerns for taxpayers about unplanned, unexpected tax rates. This can be risky, especially for co-owners of small businesses, and those set up as partnerships or LLCs.
What is Phantom Tax?
Phantom Income reported to Schedule K-1 (Form 1065) of the IRS may not be received by the partners, yet they could still owe taxes on that reported income, even if they haven't received any money, which is called phantom tax.
For instance, if a person sells their share or leaves the company early in the year, but a Schedule K-1 shows a profit to the IRS, that partnership could still be responsible for their share. Even if they no longer own it or have any claim to the company's profits.
The same idea goes for people who invest their time and hard work, called sweat equity, into a startup for a share in the business. Even if they don't receive full payment, they might still have to pay taxes on any profits the business reports.
If you’re one of those people, then you should go to a tax specialist like Virtue CPAs. We can help make sure your financial distributions meet your tax rate, that you pay taxes on any unpaid earnings, or that you have a tax rate spread out over a longer time. We have your back with our tax experts' team.
Common Causes of Phantom Income
- When the partners keep their money in the company instead of taking it, it creates phantom income, as they own it but don’t hold it in their hands.
- If you use money from operational costs to reduce the main loan, there comes phantom income. When you pay the loan’s interest, it is seen as income because it is not part of operating costs.
- When professional service firms pay large costs in advance, direct costs such as filing fees or indirect costs as software for their clients, phantom income occurs. However, the client will be billed for these later, still in the meantime, the firm's funds are tied up in these expenses, which usually cannot be deducted as operating costs.
- The phantom income arises from company deductions that the IRS rejects for regular business expenses, such as expenses that are not considered deductible.
What are Phantom Deductions?
Phantom deductions, different from phantom income, happen in professional services firms. These are expenses that the IRS permits businesses to write off which means businesses can take deductions quickly without having to report income, or they can cover costs from new capital without showing any income. It can happen when a company raises money by having an equity partner invest or by getting a line of credit.
For instance, The Paycheck Protection Program (PPP) loans are taken by many businesses. If they followed certain rules, these loans were forgiven, and the tax was waived. This allowed companies to receive funds, use them for their operations, and not face any financial burden from it.
However, you need adequate tax planning for phantom income to benefit from these deductions. So, let’s figure it out.
Phantom Income Tax Planning
Professional service firms can carefully manage phantom income to help partners get ready for tax problems by using the right tax planning methods. Here are some of them.
Phantom Income Tax Planning Method
1. Accounting Method
Many professional service firms prefer cash accounting over accrual accounting. This allows them to match income and expenses more closely with their actual cash flow, helping to reduce issues with unrecorded payments.
2. Distribution of Income
Another key part of planning for phantom income expenses is making sure everyone knows how income is distributed in the professional services firm. It's important to understand whether the company divides income by units or based on the revenue each partner brings in during the year. This is essential for proper estimation of the tax effects of phantom income.
3. Business Operations
Knowing how the business works and when products are distributed is very significant. The business office, along with its advisors, is responsible for figuring out the possible results of distributions and helping partners plan for them.
4. Operating Funds
If the company has extra operating funds, it could use this money to cover the gap between what partners earn and the cash available for their payments. This would ensure that partners have enough to pay their taxes.
5. Cash Withholding
Business offices could consider a cash withholding policy to help partners cover their distribution taxes. Many professional service firms hold back 25% of the distributions a partner is entitled to in a cash account and distribute this as a designated tax payment every quarter.
Conclusion
If you are not using the right methods, Phantom Income can quickly become a big problem for you in business. Larger, established businesses may manage many Phantom Income issues with reserved funds, but for smaller, growing businesses, Phantom Income can be an even bigger challenge.
And We are here to help you with that challenge. Contact us to get the best tax solutions.
Virtue CPAs is one of the best accounting and taxation firms in Atlanta and our tax professionals assist comprehensively with business tax, personal tax, and more.
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