There’s a hidden tax horror behind pass-through entities, cancellation of debt, and even prizes, winning, and awards: “phantom income.” It even sounds scary, right? And when it comes to one’s tax liability, it can be downright frightening indeed.
Phantom income usually refers to gain or profits that an entity reports, yet that the owner or investors in the business have not actually been distributed or otherwise received. The IRS taxes the full amount of a business’s income. But since the pass-through entity’s profits flow through to the investors, who report it on their individual returns, it creates a tax liability on the part of the individual when that gain or distribution hasn’t actually been paid. Therefore, the investor hasn’t been given the money to pay the taxes asserted.
Phantom income can also refer to discharge of indebtedness “income,” also known as cancellation of debt income. This involves a situation where a loan or debt is forgiven, discharged, or otherwise released, and barring certain facts, can be includible in the gross income of the debtor for tax purposes. Again, despite no actual cash or money received. Think about a credit card company settling your $40,000 balance for $10,000. You’ve just received phantom income of $30,000. In these situations, IRC Section 108 may control, providing limited protection by allowing exclusion of such phantom income in cases of bankruptcy or insolvency. If you’ve had the credit card debt consolidated and reduced in the course of a bankruptcy proceeding, then you’re probably safe and that $30,000 will be excluded per Section 108(a)(1)(A).
Let’s say you made it onto The Price is Right and you won big, like a brand-new car. Trick or treat? You may not be aware, but the IRS will require that you report the amount of that prize as income! To a lesser extent, this is also referred to as phantom income. While it’s true, no cash was received, you did win something of value, and make no mistake the IRS will tax it. IRC Section 74 makes clear that “gross income includes amounts received as prizes and awards.” So, enjoy that new car, but you must find additional funds to pay the taxes on your new prize.
A much more complex scenario exists when a pass-through entity goes bankrupt, and its partners are solvent. While the pass-through entity’s debts are discharged in the course of a bankruptcy proceeding, which Section 108 excludes, the flow-through nature of the discharge of indebtedness means it could become phantom income includible individually as gross income on the part of its partners. Now imagine that one of these partners went on to win an all-expense paid vacation. The phantom-income tax horror!
Often times a good planning strategy can mitigate or completely prevent the risk of significant phantom income. With any pass-through entity, it’s best to consider the benefits of incorporating precise and comprehensive tax distribution provisions and reported profit provisions into any operating or partnership agreement. It’s also wise to find a solution that can be workable for multiple states, as it’s common that partners may reside in differing jurisdictions with varying tax laws and rates.
The best way to avoid a phantom income trick is through understanding what gives rise to it in the first place, and consulting with tax advisors that are knowledgeable about it as well. Treat yourself to careful tax planning to prepare for phantoms lurking in the shadows.