Phantom Income, Real Taxes

Imagine receiving a tax bill for income that never made its way into your bank account. It sounds like a mistake, but it’s not.

This is the result of phantom income. It’s one of the most misunderstood risks in certain investment structures, and it shouldn’t be ignored because it can have consequences when your tax advisor prepares your tax return.

Yet, it’s a very real phenomenon that can catch even seasoned investors off guard. You owe income tax on earnings that were allocated to you on paper but never distributed in cash.

For investors in various partnerships, LLCs, private equity funds, or real estate ventures, this issue is common. Profits may be reinvested or retained by the entity, but the IRS still considers your share taxable.

Let’s put it another way. Phantom income occurs when tax law treats your earnings as taxable to you, even though the cash stays in the business or remains neatly tucked inside your investment.

So, let’s look at some situations that could exacerbate your tax bill without providing the cash liquidity to pay Uncle Sam.

As always, when it comes to taxes, feel free to reach out to us with any questions or consult your tax advisor for guidance.

Seven prime examples

Phantom income can creep onto our tax return in various ways, creating an unexpected strain on cash flow and financial planning.

1. Open-ended mutual funds. Mutual funds typically pay dividends regularly, whether that be monthly, quarterly, or annually. If accumulated by an actively managed fund, it also distributes capital gains, both long- and short-term, to its shareholders.

But what if you, as a shareholder, reinvest dividends and capital gains? While reinvesting payouts are an important component of building long-term wealth, if the fund is held in a taxable account, you will receive Form 1099, and you’ll need to report the income to the IRS, which can result in a tax liability.

2. Debt forgiveness. If a lender erases a debt that you owe, the IRS often sees that as taxable income, even though you didn’t receive cash.

Think about it: If debt on real estate, a student loan, or a credit card balance gets forgiven, that canceled amount may wind up as “phantom income” on your tax return.

In most cases, the lender will send you a Form 1099-C, which reports the forgiven debt as income. That means you could owe taxes on money you received in the initial loan that was forgiven by the lender.

3. A zero-coupon bond. A zero-coupon bond is sold at a steep discount and matures at face value. It doesn’t pay a regular coupon, so “interest” is effectively compounded and paid in a single lump sum at maturity.

Yet, the IRS treats the accrued interest as taxable income each year, and you will receive a Form 1099-OID with the computed coupon each year, even though you never received a cash payment.

4. Something similar happens with TIPS (Treasury Inflation-Protected Securities), but with a twist.

TIPS are bonds designed to protect the bondholder from higher inflation. If the principal is adjusted upward for inflation, that increase is considered taxable income—you are presented with a tax bill if held in a taxable account—in the year it occurs, even if you don’t receive the cash until maturity or sale of the bond.

In summary, TIPS provide regular coupon payments. Still, they may also create phantom income for taxes because any inflation adjustment to principal is taxable each year, even though you don’t receive that extra principal until maturity or sale.

5. Non-cash compensation. We intuitively understand that our wages and salaries are subject to taxes. But what about those perks that add to compensation?

Health benefits for your partner (non-spouse), a house or apartment that’s paid for by your company, a company car, or employer-paid life insurance may be viewed as taxable income by the IRS.

6. Limited partnerships. If you’re a limited partner in a pass-through entity like a partnership, here’s something that can catch you off guard when tax time rolls around.

You might owe taxes on profits allocated to you even if the business didn’t send you a cash distribution. Why? Because the IRS taxes you based on your share of the profits, even though they were not paid out as actual cash distributions. These are recorded on Schedule K-1.

7. Private equity and law firms. If you’re a business owner or partner in a firm, your operating or partnership agreement usually spells out how profits and losses are allocated for tax purposes. Here’s the catch: Those allocations count as income on your tax return, even if you didn’t actually receive any cash.

Taking steps to minimize phantom income and the tax bite

• Utilize tax-advantaged accounts such as an IRA or 401(k): You may choose to hold open-ended mutual funds, zero-coupon bonds, and TIPS in a retirement account to defer taxes.

• If you are buying a mutual fund in a taxable account, wait until after the capital gain and dividend distribution is made to avoid being assigned income that accumulated in the fund throughout the year. If your timing is unfortunate, you could own it for only one day but still be responsible for the entire distribution.

• Tax-efficient funds: While we want to ensure that tax considerations don’t overshadow solid investment choices, mutual funds with lower turnover can help reduce unexpected capital gains distributions. Or, consider tax-efficient exchange-traded funds (ETFs). They distribute dividends to shareholders, but capital gain distributions are rare.

• Update partnership agreements: If you’re in a partnership or S corporation, can you, with the assistance of your tax attorney, review your operating or partnership agreement and consider adding a tax distribution clause? If so, this may allow the business to make cash payouts to partners to cover their tax bills on allocated profits. It’s a simple way to avoid scrambling for liquidity when phantom income lands on your tax return.

• Stay engaged: Don’t wait until filing your tax return to discover there is phantom income lurking in the shadows! Be proactive and monitor your tax obligations throughout the year.

  
  

In short, don’t rule out investments that generate phantom income. They may fit well in your portfolio and help you move toward your financial goals.

Just remember: A tax bill could be lurking in the background. The key is preparation.

If you have specific questions, we’d be happy to address your concerns, or we’d love to hear your thoughts. As we highlighted above, also feel free to reach out to your tax advisor.