Phantom Income: What It Is and How It’s Taxed

On the balance sheet, you’ll want to look at the accounts receivable number. This is the amount of money that the company is owed by its customers. If this number is high, it means that the company is waiting on payment for products or services that have already been provided. This can lead to phantom profit because the company appears to be making money, when in reality, they’re just waiting on payment. Companies should employ a tax professional to plan for phantom income phantom profit formula tax.

If there is a difference between this historical cost and the current cost at which it can be replaced, then the difference is said to be a phantom profit. Managers need to be aware of phantom profits, especially when there is a substantial difference between the old cost layers and replacement costs. Once the old cost layers have been eliminated, managers may find that their reported profit levels suddenly decline. According to their LIFO accounting, they will record a profit of $5 ($20 selling price – $15 COGS). But in reality, if they sold a widget that was manufactured in January, their actual profit is $10 ($20 selling price – $10 COGS).

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). 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 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. Under GAAP the amount of depreciation expense reported in the financial statements is based on the historical cost of the asset and is not based on the asset’s replacement cost.

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However, the company’s financial analysts have done some preliminary work and they believe that the project has the potential to be profitable. Thirdly, businesses need to price their products and services correctly. This is important because if prices are too low then businesses will make a loss, but if prices are too high then customers will go elsewhere. When it comes to business, there are a lot of different ways to calculate profit. However, when it comes to phantom profit, there are a few key things you need to keep in mind.

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. Another form of phantom income can result from the cancellation of debt. Essentially, the creditor pays the delinquent borrower the amount of the debt forgiven. Creditors send taxpayers Form 1099-C, which shows the amount of “income” received in the form of forgiven debt. Taxpayers can complete IRS Form 982 to reduce taxes on their forgiven debt.

1. Some real estate investing practices can create phantom income where taxable income may exceed the proceeds of a property sale because of previous deductions.
2. This can lead to over-investment and, ultimately, financial problems down the road.
3. These are usually the result of accounting practices or changes in market conditions rather than real economic gains.
4. As long as the company is aware of the potential risks and accounting for them appropriately, there’s nothing wrong with this practice.
5. This is because they are not actually generating enough cash to fund their operations.

For example, an electric utility is depreciating (and usually charging its customers) the original cost of a power plant until the plant is fully depreciated. However, the utility is using up the economic capacity of that plant and the economic capacity might have a replacement cost that is three times as much as the plant’s original cost. The utility (or any manufacturer depreciating productive assets) will be reporting higher profits using depreciation expense based on old low cost instead of current replacement cost.

Taxation

For example, if the retail price is $100 and the desired profit margin is 10%, the profit will be $10. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia. All information published on this website is provided in good faith and for general use only.

And even though zero-coupon bonds make no payments until maturity, their holders may be liable for local, state, and federal taxes on the amount of their imputed interest. This phantom income can be offset by purchasing tax-free zero-coupon bonds, tax-advantaged municipal zero-coupon bonds, or zero-coupon bonds. Phantom income can occur when an individual is taxed on the value of their stake in a partnership even if they do not receive any cash benefits or compensation. For joint owners of small businesses structured as partnerships or LLCs, income may be reported to the Internal Revenue Service (IRS) on Schedule K-1 (Form 1065), but not received by the participants. If the reported income is significant, a partner may have to pay tax on the amount of the reported income.

Understanding Phantom Gain

The resulting higher profits (the difference between the depreciation under GAAp versus the depreciation based on replacement cost) are phantom or illusory profits. The additional profit from this difference in depreciation is considered to be illusory profit. However, if replacement cost had been used, the company’s profits would have been higher since these costs don’t factor into calculating these deductions.

On the other hand, if the project turns out to be even more profitable than expected, the company can reinvest the phantom profit back into the project to accelerate its growth. This is the present value of the opportunity cost minus the cost of the alternative course of action. These benefits are taxable even though the employee has not received cash and the value will be included in an employee’s 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.

For example, a company may recognize revenue as soon as a contract is signed, even if the work has not yet been performed. It is difficult to determine if a company is making phantom profit because there are many ways to manipulate financial statements. Some common ways to manipulate financial statements in order to make phantom profit are through the use of aggressive revenue recognition, off-balance sheet financing, and creative accounting. The most common type of phantom profit arises from the sale of a capital asset, such as a stock or bond. When the asset is sold, the taxpayer recognizes a capital gain or loss.