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Phantom income is income that doesn't produce any cash for an individual or a company, but is still taxable because it shows up on income statements. This is particularly troublesome to the person or persons involved because they may lack the liquidity to pay off these taxes. Individuals in charge of limited liability companies and other similar arrangements are often susceptible to phantom income because all monies made by the business are attached to their personal accounts. Other causes of this phenomenon include zero coupon bonds, loans that are forgiven, or poor accounting techniques by businesses.
Corporations are usually free from phantom income because the corporation itself bears the responsibility for paying income taxes, as opposed to the individuals within it. Smaller companies, such as limited liability companies, which are often owned by a single person or a small partnership, can find themselves dealing with the problem of income taxes due without any liquidity to pay for it. This often occurs because the company is taking all of its income and putting it back into the business rather than saving some for taxes.
For example, imagine a company that makes an annual income of $500,000 US Dollars (USD). Particularly if it is an up-and-coming company, the principal owner might take out a small portion such as $50,000 USD for himself and then put the rest of the income right back into the business for operating expenses, marketing, or any other cost accrued by a growing business. The problem arises when income taxes are due, because the owner is liable for the income tax bill on $500,000 USD, yet now lacks the cash to pay for it.
To avoid this problem, such owners must make sure to pay themselves enough to account for the income taxes. In the case of a minority partner who lacks the decision-making power to decide what she should be paid, she should make sure that her original contract stipulates that a certain amount of money be reserved for her to pay off her income taxes. Companies also have to be wary of knowing what business expenses may or may not be written off to avoid phantom income rising up to cause problems.
Zero coupon bonds are a common cause of phantom income. They yield no interest to those who possess them, but, because they are sold at a discount, are technically still profitable to their owners and thus taxable. Loans that are forgiven can also be problematic because the tax is still applicable even though the principle of the loan may be long gone. In general, individuals and business owners should be wary about any lag time from when income is received to when the taxes on that income are due.
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