Avoid Phantom Income

Financial planning is much more than just figuring out how much to save for retirement. One goal of financial planning is to match your personal goals with your finances so money doesn’t hold you back from achieving your dreams, be it owning your own business, retiring early, or traveling the world. The process of financial planning often looks for places where you can help prevent yourself from losing money and phantom income is one of those places.

What is Phantom Income?

Phantom income, also known as phantom revenue, essentially has to do with taxes and how your assets are viewed as income by the government. Income that is reported to the IRS but isn’t actually ever seen by the person who reports the income is known as phantom income. For instance, if you have a partnership or joint venture, the value of your shares in the company’s profits is seen as income. While you may not receive any money into your bank account from those shares to the amount they are valued, you’re taxed based on that value.

For example, imagine that you have 10 shares in a company that earned $50,000 in profits last year. Imagine further that the company didn’t pay dividends last year. Paying out dividends isn’t always possible or the smartest option, depending on the company’s health and rules on reinvestment requirements. So you had no income from the company last year — or at least no income that you could spend.

You’d still be taxed on $5,000 of that profit, even though you didn’t receive $5,000 into your pocket that year if money was kept as retained earnings instead of paying it out in dividends.

Other things that can cause phantom income are debt forgiveness, sweat equity, and zero-coupon bonds. The basic idea is that the IRS sees these things as assets that increase your overall personal value because you’re profiting in some way from these transactions, even though you may never see a cent of the value. When it comes to tax time, it can mean paying on money you didn’t receive. It can be disastrous for your financial health if you’re unable to pay and accrue interest on your back taxes or have to dip into savings to pay for taxes.

How can I avoid Phantom Income?

Financial planning helps you avoid phantom income sources or help to ensure that you can pay the taxes on your phantom income by setting up transactions appropriately. There are a number of techniques to help avoid phantom taxes. They range from declaring insolvency, where your debts are bigger than your assets, to setting up a partnership so you’re paid out enough to pay taxes, or avoiding sweat equity by setting up capital investments as loans.

None of these techniques should be taken lightly, though, because they can have serious effects on your finances. By taking into account all of your assets that may incur phantom income and resolving the issues as much as possible, you could see a significant increase in your overall financial health.

Before you make any big changes in your finances, like investing in a company or starting a new business, you should consult a financial planner to make sure you’ve got yourself covered when it comes to phantom income. Taking care of the problem before it happens can help you avoid big tax surprises down the road. If you’ve made choices that resulted in phantom income, your financial planner can give you advice on how to get rid of phantom assets.

One of the first things we do during our financial planning sessions in discovery, the time when we’re getting acquainted and learning about your assets, is look for areas where you might have phantom income. By isolating these areas, we can help you avoid phantom income and make a positive impact on your finances. If you’ve got phantom income that’s negatively  impacting your overall financial health, talk to us to find out how you can pay less in taxes next year.