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The Eerie Presence of Phantom Income

What is Phantom Income?  - TaxACT Blog

Halloween evokes spooky images of ghosts and goblins. These specters may not be visible to the eye, but rumor has it, their eerie presence can be felt.

Similarly, so-called “phantom income” is money that you don’t actually pocket, but the IRS still treats those funds as taxable income.

Nobody likes getting a larger than expected tax bill, especially on money they never actually had, but because the money (or “imputed income”) shows up on income statements, it’s fair game for Uncle Sam.

These situations are not very common, but here are a few examples of phantom income:

Non-spousal medical benefits

A growing number of employers offer healthcare coverage to domestic partners in addition to legally married spouses.

A spouse’s medical benefits are not taxable, but when two people (a same-sex couple or otherwise) aren’t legally married, the non-employee’s benefits are taxable.

Not all states recognize same-sex marriage, so some employers have begun to “gross up” domestic partner benefits, meaning that the employer pays the taxes on those benefits rather than the employee.

Still, if both partners have employers offering health insurance, they should compare the cost and coverage of both plans to see which plan makes the most sense.

In some cases, signing up for insurance through their own employers may be more cost effective and shouldn’t incur extra taxes.

What is Phantom Income? - TaxACT Blog

Forgiven income

If you have credit card debt or loans forgiven, the lender may report the amount on IRS Form 1099-C (“Cancellation of Debt“).

The same may be true of a short sale or foreclosure, because the mortgage lender is allowing you to walk away from the property without paying off the mortgage balance.

While you’re not actually getting that money, you may still owe taxes on the forgiven amount.

This may not be as scary as it sounds, because there are some exceptions to taxes on forgiven debts.

There used to be an exception for mortgage debt that was forgiven through the short sale or foreclosure of your primary residence.

Unfortunately, the law that allowed that exception, the Mortgage Forgiveness Debt Relief Act, expired at the end of last year.

However, debts forgiven during bankruptcy or when you are not financially solvent are not taxable, so even though the Act has expired, you may be exempt from taxes on those cancelled debts if your debts exceed your assets.

If you’re filing bankruptcy or dealing with cancelled debts, then you may want to consult an attorney about the potential tax implications and avoid any nasty surprises come tax time.

File IRS Form 982 to exclude discharged debt from your gross income.

Owning an S corporation or LLC

Individuals who own these types of business entities may receive money through their S corp or LLC and need to pay taxes on (phantom) income before they actually receive that income, which can be frustrating.

In the case of a corporation, however, the business, not the individual, owes the tax.

If you’re setting up an S corp or LLC, talk to your business attorney or accountant about how these structures may impact your taxes.

Receiving equity in a business

If you’re investing “sweat equity” in a startup venture, while someone else is providing the cash, receiving a percentage of equity in the business could create tax implications for you.

One way around this might be for the investor fronting the cash to lend the money to the venture or to have the person providing sweat equity to buy shares of equity over time.

Consider the potential tax impact before you set up an equity structure for a new venture.

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About Susan Johnston

Susan Johnston is freelance writer who's covered personal finance and small business for publications including Bankrate.com, The Boston Globe, Entrepreneur.com, Learnvest.com, and USNews.com. Follow Susan on Twitter.