What is Phantom Tax? Understanding Phantom Income and Tax

December 15, 2023 - Friendly Tax Expert

Phantom tax may be something you've heard before.

Or perhaps, it's a term you've come across for the first time.

Either way, understanding what phantom tax is and how it could potentially impact your finances is important.


Because this type of tax can sneak up on you and you may find yourself paying more taxes than you anticipated.

Phantom Tax Definition

Phantom tax is a financial phenomenon where you're required to pay tax on income that you haven't actually received.

How does that happen?

Is that even possible?

Well, the bad news is that it is possible and it actually happens.

This kind of tax occurs when you are entitled to phantom income.

Now, what does that mean?

Phantom income is any income that is earned but not yet distributed to you.

On paper, it's the money you've earned but never made it into your pocket.

This is where the word "phantom" comes from, as it is not income that you can physically see or touch.

However, this income is still counted as taxable income even though you haven't received a penny of it.

This can happen in various scenarios such as stock options, bonuses, or partnerships.

In essence, phantom tax arises from phantom income that has not been physically received in cash.

When Does Phantom Tax Occur?

Now that you know what phantom tax and phantom income are, the next question is probably...

...when does phantom tax actually occur?

Knowing whether you're at risk for phantom tax can help you prepare and potentially avoid any unexpected tax bills.

As mentioned, there are different situations where phantom tax can occur.

Some of these situations may seem familiar, while others might not.

It also depends on your local tax laws and regulations.

Woman in a blue polo reading tax files

Examples of When You Might Be Liable to Pay Phantom Tax

To give you a better idea of how phantom tax occurs, let's break it down with an example.

Say you invested in a company and for this year, your share of the profits amount to $10,000.

However, you and your partners decided to reinvest the profits to grow the business.

So instead of cashing in the check, your ten grand remains in the company.

While you haven't received any cash, your share of the profits is still counted as income and therefore, subject to tax.

This means that you will have to pay taxes on that $10,000 even though you never actually received it in cash.

If you don't understand that you may be liable for taxes on income you never received...

...this may catch you (and your bank account) off-guard when tax season comes around.

Another scenario is when you get awarded stock options from your employer based on "sweat equity."

Sweat what?

"Sweat equity" is when you exchange effort or work for equity in a company.

In this case, your stock options are considered phantom income until they become vested and exercisable.

The thing is, you still have to pay income tax on those stock options even if you can't cash them in yet.

Just imagine if the value of those stock options increases significantly in a span of a year.

You could end up paying a huge chunk of money in taxes on paper gains that you haven't actually received come tax season.

How to Handle Phantom Tax

The best way to handle phantom tax is to be aware that it exists and understand when it could potentially occur.

This will help you plan ahead and avoid any surprises on your tax bill.

You can also proactively manage your phantom tax liabilities by following some practical tips.

An individual solving tax

Accurate Record-Keeping

Keep detailed records of all income, including any phantom income. This will help you stay aware of any potential tax liabilities and plan accordingly.

LLC Partnership Agreement

If you're joining a limited liability company as a partner, it's advisable to include a provision in the agreement that ensures the company distributes sufficient profits to cover taxes on any phantom income.

Sweat Equity Partnerships

If you're joining an LLC as a sweat equity partner, you may want to sign a promissory note to spread out payments over time. This can help with managing large tax bills.

Stay Informed

Keep up-to-date with tax laws and regulations. These can change from year to year and staying informed can help prevent unexpected tax liabilities.

Take note that these tips are not exhaustive and it's always advisable to seek advice from tax professionals.

Take Control of Your Tax Responsibilities

Yes, phantom tax may seem like a scary concept...

...but with knowledge and preparation, it can be managed.

By understanding what phantom tax is, you can take steps to mitigate potential tax liabilities.

If you need any help or advice on handling phantom tax, don't hesitate to contact us.

We can help you stay on top of your finances and take control of your tax responsibilities.