Let’s say that you have phantom profit a stake in a partnership that reports $50,000 in income for the fiscal year. Your total shares are worth 10%, which means you would have a tax burden on $5,000 in the reported profit. Even if you decide to leave the profit in the company you might still be required to pay tax on the $5,000 although you didn’t take a payout.
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Had the replacement cost of the product been used, the cost of goods sold might have been $145. Assuming the product was sold for $165, the financial statements will report a gross profit of $65 ($165 minus $100). If replacement cost would have been allowed and used, the gross profit would be $20 (selling price of $165 minus the replacement cost of $145).
What Is a Phantom Gain?
The terms phantom profits or illusory profits are often used in the context of inventory (but can also pertain to depreciation) during periods of rising costs. Typically, phantom income in real estate occurs when the proceeds of a property sale are lower than the taxable amount. A property owner is allowed to claim depreciation expenses over time to help offset rental income, which is decreasing the base cost of the property increasing the potential of a capital gain.
Understanding Phantom Gain
- If the stock price rises to $75, the employee could exercise the options, buy the shares for $50,000, and then sell them for $75,000, realizing a profit of $25,000.
- It’s essential for both the company and the employees to consult with tax professionals to understand the tax consequences of a phantom stock plan.
- In a stock option plan, employees are granted the right to buy a specific number of company shares at a preset price (strike price) within a given time frame.
- Phantom income can also occur in any number of business types and situations.
These can include debt forgiveness, certain benefits, and owners of limited liability corporations (LLCs) or S corporations, for example. A phantom gain is a situation in which0 an investor owes capital gains taxes even though the investor’s overall investment portfolio may have declined in value. Phantom gains are situations where an investor’s portfolio declines in value but they’re still required to pay capital gains taxes. Since it’s still early in the life of the LLC, both Jim and Jennifer decide they won’t want to withdraw any funds, but rather reinvest the profits to help the business grow. You might want to do things on your own and start a sole proprietorship or you might have a partner who you want to enter into a partnership with. There are also more, such as limited liability corporations (LLCs) or an S corporation.
Some real estate investing practices can create phantom income where taxable income may exceed the proceeds of a property sale because of previous deductions. Phantom income in real estate is often triggered by the process of depreciation, whereby owners decrease the value of a property over time to offset their rental income. For example, if a partnership reports $100,000 in income for a fiscal year–and a partner has a 10% share in the partnership–that individual’s tax burden will be based on the $10,000 in profit reported.
The amount of phantom or illusory profit was $45 ($65 reported minus $20 measured using replacement cost). An economist would argue that you must first replace the item before you can measure the profit. GAAP doesn’t allow the use of replacement cost since that violates the (historical) cost principle.
The resulting higher profits (the difference between the depreciation under GAAp versus the depreciation based on replacement cost) are phantom or illusory profits. Phantom gains are sometimes confused with phantom income, which is actually a different and broader concept. One example of phantom income is debt forgiveness, which the IRS treats as taxable, even though the taxpayer liable doesn’t actually receive any cash from which he can pay the tax. The historical cost using the first-in, first-out (FIFO) cost flow might have resulted in $100 per unit appearing as the cost of goods sold on the recent income statement.
Phantom income doesn’t happen too often, but if you’re not prepared for it to happen it can cause unintended tax complications. Let’s say an employee is granted 1,000 phantom shares under an appreciation-only plan when the company’s stock price is $50. After a vesting period of three years, the company’s stock price has risen to $75. A tax distribution clause can be included in a partnership’s or LLC’s business operating agreement. A tax distribution clause requires the business to make distributions to cover the member’s tax liability from allocated income.
This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as stable. Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used as a reward or a bonus to employees who meet particular criteria.