what is phantom tax

Phantom income is a tax liability for an individual or partnership on income that has not been distributed to them yet. It is typically an investment gain that has not yet been realized through a cash sale or a distribution, but it still creates a tax liability for the taxpayer. Phantom income can arise from investment gains that haven’t been sold or distributed to the investor, debt forgiveness, certain benefits, owners of limited liability corporations (LLCs) or S corporations, and real estate investing, among other scenarios. It can make tax planning more difficult because, even though it has not been realized, it is income that is attributed to ones tax liability. Phantom income can pose challenges for taxpayers when it is not planned for because it can create an unexpected tax burden. The biggest problem with phantom income occurs when an owner decides to reinvest their profits into the business. Since no actual cash is paid out, it can sometimes be confusing to still have to pay taxes. To avoid this, it is recommended that the impacted parties consult with a tax professional to ensure that their cash distributions cover their tax burden or that the company will pay the taxes on undistributed phantom income.