Tax Policy

What is Phantom Income?

What's scarier than paying taxes? Paying taxes on income you didn't get cash for. That's exactly what phantom income is.

What’s scarier than paying taxes? Paying taxes on income for which you didn’t get cash. That’s exactly what phantom income is. It’s not common, but when it happens it can leave any taxpayer scared. Here are some examples of phantom income and how they might creep up on you.

Debt Forgiveness

If you’ve ever found yourself in tough times and unable to pay your credit card bills, then you might have seen phantom income. Credit card companies that are unable to collect will often settle for a smaller amount to close the balance of the account.

Say, for example, you owe $5,000 in credit card debt and you reach a deal to pay $1,000 for full settlement of the account. The $4,000 that was forgiven would be considered income (yes, phantom income!). You’ll receive a 1099-C and have to report the amount as other income on your tax return.

This can be an unwelcome surprise for some taxpayers who settle thousands of dollars in debt. Imagine having $10,000 in credit card bills forgiven only to find out you’ll have to pay tax on that $10,000? Chances are if you couldn’t pay the bills in the first place, then you can’t afford the tax bill either.

But don’t worry too much – bankruptcy protection helps avoid these tax situations by exempting most forgiveness of debt from being classified as taxable income. For more information, consult a lawyer.

Winning A Brand New Car!!!

Have you ever seen those game shows where people win a brand new car? How lucky are they, right? But if you look closely, you’ll see phantom income lurking behind them.

Like most income, you’ll need to report all that money you won from game shows such as Jeopardy! as taxable income – cars, and winnings from gambling at casinos are no exceptions. However, getting cash is much easier to report and subsequently pay tax on than other types of winnings as you can simply save a portion of it for when the tax man comes knocking at your door.

So, what happens if you win a car, or other vehicle such as a boat or ATV? Well, you’ll have to pay taxes on the fair market value of it. If you win a $25,000 car on a game show then you’ll need to pay taxes on $25,000 worth of income. With no cash winnings, you’ll quickly wish you never won the car.  The taxes you will end up paying on the car will not be as much as $25,000, so it’ll be somewhat free.  Also, you will even have to pay taxes on the market value of a vacation package you might win.

Expensing Financed Business Property

For those who own a business, they might be familiar with Ta Code Section 179. This deduction allows business owners to write off up to $500,000 in qualified business equipment that would otherwise be depreciated over several years. This allows business owners to purchase new equipment and take the full tax benefit in the year of purchase.

You can even write off new equipment that was acquired through financing. So imagine this – a business owner has $200,000 in taxable business income and wants to reduce that amount before the close of the tax year. She can go out and purchase a piece of equipment for $100,000 through financing and take the total $100,000 as a write off in the current year – saving thousands in taxes upfront without having to pay cash for the equipment.

It might sound great, but phantom income strikes again! Since you took the total deduction in year 1, you won’t be able to deduct the principal payments over the life of the loan. Money will be going out to pay for the equipment but only the interest portion will be tax-deductible.

You’ll soon notice that your cash inflows and outflows don’t line up with your taxable income and you’ll be paying taxes on phantom income!

Investing In Flow Through Entities

Say a good friend of yours wants to start a business but needs some cash to get everything up and running. He offers you 25% of the business if you give him $50,000. Being a good friend, you give him the money knowing the business will be a huge success and you’ll be a millionaire in no time (just don’t tell your wife).

The first few years have its ups and downs but the business is running a small loss. After a few years the business takes off and your friend has a great year. He makes $1,000,000 in income just like you knew he would!

But if the business is a pass-through entity (Partnership, S-Corp, LLC, etc.) you’ll have to pay taxes on your share of the earnings regardless if you received cash. If the business is taking off and the money is tied up in existing projects so your friend can’t easily give you the money to pay the tax bill, you’ll have to find a way to come up with the money.

How to Combat Phantom Income

The best way to defeat phantom income is through knowledge and tax planning. If you suspect you may be a future victim of phantom income, consulting with a tax advisor will prepare your for any unexpected tax liabilities. After all, the worst thing you can do is fight phantom income alone – you’ve been warned!

Jeremias Ramos is a CPA working at a nationally recognized full-service accounting, tax, and consulting firm with offices conveniently located throughout the Northeast. Jeremias specializes in tax and business consulting with focus areas in real estate, professional service providers, medical practitioners, and eCommerce businesses.

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