Phantom income doesn’t happen too often, but if you’re not prepared for it to happen it can cause unintended tax complications. Let’s say an employee is granted 1,000 phantom shares under an appreciation-only plan when the company’s stock price is $50. After a vesting period of three years, the company’s stock price has risen to $75. A tax distribution clause can be included in a partnership’s or LLC’s business operating agreement. A tax distribution clause requires the business to make distributions to cover the member’s tax liability from allocated income.
- If replacement cost would have been allowed and used, the gross profit would be $20 (selling price of $165 minus the replacement cost of $145).
- It reassures employees since phantom stock programs are generally backed in cash.
- Taxpayers can complete IRS Form 982 to reduce taxes on their forgiven debt.
- Since zero-coupon bonds pay no interest until they mature, their prices fluctuate more than normal bonds in the secondary market.
FAQs About Phantom Income
Phantom stock can be given to every employee, either across the board or distributed according to performance, seniority, or other factors. However, in most cases, companies opt for appreciation-only grants, where awards are based only on total share return rather than the initial value. Companies often aim to create performance and award leverage like stock options. In addition, discounted grants and grants that pay out when returns exceed a specific hurdle rate are also used.
Let’s say that you have a stake in a partnership that reports $50,000 in income for the fiscal year. Your total shares are worth 10%, which means you would have a tax burden on $5,000 in the reported profit. Even if you decide to leave the profit in the company you might still be phantom profit required to pay tax on the $5,000 although you didn’t take a payout.
The terms phantom profits or illusory profits are often used in the context of inventory (but can also pertain to depreciation) during periods of rising costs. Typically, phantom income in real estate occurs when the proceeds of a property sale are lower than the taxable amount. A property owner is allowed to claim depreciation expenses over time to help offset rental income, which is decreasing the base cost of the property increasing the potential of a capital gain.
Is Non-Cash Compensation Considered Phantom Income?
The amount of phantom or illusory profit was $45 ($65 reported minus $20 measured using replacement cost). An economist would argue that you must first replace the item before you can measure the profit. GAAP doesn’t allow the use of replacement cost since that violates the (historical) cost principle.
What Is a Phantom Gain?
Some real estate investing practices can create phantom income where taxable income may exceed the proceeds of a property sale because of previous deductions. Phantom income in real estate is often triggered by the process of depreciation, whereby owners decrease the value of a property over time to offset their rental income. For example, if a partnership reports $100,000 in income for a fiscal year–and a partner has a 10% share in the partnership–that individual’s tax burden will be based on the $10,000 in profit reported.
The resulting higher profits (the difference between the depreciation under GAAp versus the depreciation based on replacement cost) are phantom or illusory profits. Phantom gains are sometimes confused with phantom income, which is actually a different and broader concept. One example of phantom income is debt forgiveness, which the IRS treats as taxable, even though the taxpayer liable doesn’t actually receive any cash from which he can pay the tax. The historical cost using the first-in, first-out (FIFO) cost flow might have resulted in $100 per unit appearing as the cost of goods sold on the recent income statement.
This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as stable. Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used as a reward or a bonus to employees who meet particular criteria.
These can include debt forgiveness, certain benefits, and owners of limited liability corporations (LLCs) or S corporations, for example. A phantom gain is a situation in which0 an investor owes capital gains taxes even though the investor’s overall investment portfolio may have declined in value. Phantom gains are situations where an investor’s portfolio declines in value but they’re still required to pay capital gains taxes. Since it’s still early in the life of the LLC, both Jim and Jennifer decide they won’t want to withdraw any funds, but rather reinvest the profits to help the business grow. You might want to do things on your own and start a sole proprietorship or you might have a partner who you want to enter into a partnership with. There are also more, such as limited liability corporations (LLCs) or an S corporation.
Had the replacement cost of the product been used, the cost of goods sold might have been $145. Assuming the product was sold for $165, the financial statements will report a gross profit of $65 ($165 minus $100). If replacement cost would have been allowed and used, the gross profit would be $20 (selling price of $165 minus the replacement cost of $145).
Phantom income occurs when some type of financial gain hasn’t been paid out yet but one is responsible for paying taxes on it. It often arises from investment gains that haven’t been sold or distributed to the investor. It reassures employees since phantom stock programs are generally backed in cash.