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Phantom Income: Examples and Explanation

written by: Steve McFarlane•edited by: Jean Scheid•updated: 8/28/2010

What is phantom income, who is liable to pay it, and what are some examples?

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    For the purposes of taxation, phantom income is any income that doesn’t generate cash but is nonetheless subject to income tax. Tax laws recognize the fact that there are some business transactions that can improve the taxpayer’s financial standing even though money didn’t change hands. Some examples include a debt that was forgiven and income distribution from a limited liability company (LLC) or partnership.

    Phantom income is recognized as an allotment of resources that the individual doesn’t receive as cash or cash equivalents. In other words, the individual does not realize a positive cash flow, but is deemed to have benefited in other ways. Here are some examples.

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    Examples of Phantom Income and Its Definition

    Phantom is recognized as an allotment of resources that the individual doesn’t receive as cash or cash equivalents. In other words, the individual does not realize a positive cash flow, but is deemed to have benefited in other ways. Here are some examples:

    Zero coupon bonds – Also called discount or deep discount bonds, zero coupon bonds are instruments that do not pay interest on aWhat is phantom income Tax – a definition of phantom income  periodic basis. Instead, the bonds are purchased at a discounted rate (less than their face or redemption value) and the increase (compounded interest) is realized when the full face value is paid to the bondholder at maturity.

    Forgiven debt – These include loans, such as mortgages, auto loans and credit card debt that were forgiven by a creditor. By forgiving a debt, the creditor is in effect giving the debtor the forgiven amount. There may be exceptions, however, as in the case of transactions that are addressed under the Mortgage Forgiveness Debt Relief Act of 2007 that was signed into law by President Bush.

    The Act was a means of stemming the rate of foreclosures in the mortgage market. Under the act, the homeowner has no liability to pay federal income tax on the debt that was forgiven in relation to a loan that was secured by a qualified principal residence, but this was allowed only if the debt was forgiven for the sake of avoiding a foreclosure on the property.

    Income distribution in a partnership – Income tax may become due on income that is distributed to shareholders (i.e. in S corporations) regardless of whether or not they receive the money. For example, if Bob and Rick own a business (51% to 49% respectively), but Bob takes a decision to not distribute the profits, both parties may still be liable to pay taxes based on the undistributed income. This is why it is a good idea to include a clause in the partnership agreement that requires that at least enough money should be distributed among the shareholders to cover taxes.

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    Conclusion

    For obvious reasons, taxpayers detest phantom income taxation, especially when it creates a liability in cases where the taxpayer doesn’t have the means to pay. A typical example is a case where credit card debts have been written off, even though hard times have forced the card holder to default on the debt. The tax framework is not primarily concerned with the ability to pay, however. Rather, it makes Phantom income Tax, Tips and definition assessments for tax liabilities based on the flow of value to the taxpayer.

    Image Credits:

    1. "Phantom income Tax, Tips and definition" Phillip
    2. "What is phantom income Tax – a definition of phantom income " David Reber's Hammer Photography