What is phantom income and how does it happen?
Well, phantom income generally is the deposits of a company were accurately reported, because those people get sent 1099s from their jobs. They deposit money in their checking account. It’s not hard to track the income of a company from deposits and tax records that are mailed to them by the people that pay them so that part’s almost always right. The problem is people don’t know how to properly categorize, document, nor do they even think about expenses being a business expense rather than a personal expense when they are a sole proprietor. They simply don’t claim the deductions, the offsets that are supposed to go against those gross revenues before they report their profit to the IRS.
A $58,000 business consulting income, because a teacher retires from a school district and helps a struggling school district to set up new management and work flows as an independent contractor, gets his 1099 from the two schools that he worked for totaling $58,000. He did most of the work from his home computer and his cell phone. He drove to each one of the schools a couple of times a week. He claimed a few dollars in mileage, but reports $45,000 of profit after expenses against the 58K on schedule C on his tax return. That escalated the teachers’ pension and other incomes up to the 33% tax bracket. That’s phantom income that we at our tax planning firm see over and over again, because nobody on earth has a business that returns a 500% profit. They simply didn’t know how to deduct or properly categorize or document the things that they considered personal expenses, but by the IRS’ guidelines could have easily been actual expenses against that income. They said yes and did the consulting, but then they didn’t take a course in properly documenting use of vehicles, meals and entertainment, travel, personal education, legal fees, office expenses, and all of the other things that they took for granted and did not deduct.
Expenses like a home office deduction, cost of a new laptop, all sorts of things that were supposed to be taken as deductions against that gross income but simply weren’t because they walked into a tax office and said, “Oh, I earned this consulting this year”, to which preparer asked, “do you have any expenses to go against this?” and they said, “hmmmm, not really, some mileage I guess”, not realizing how detrimental the lack of caring about the deductions would be on their personal tax return until it was too late.
Go onto Google and look how much average percentage of profit does the owner of a restaurant make? How much profit does the owner of a tire store make? You won’t see 100% profit, 50% profit, as industry averages of Fortune 500 companies, the margins are much smaller. When you see it happen on a personal tax return, out of the lack of taking deductions, make them think in these same terms.
Most of the time it’s deductions that make phantom income go away. They’re legal, they’re applicable, and they’re so often completely missed. Unfortunately reported to the IRS by preparer`s that didn’t want to force the conversation and say “no” to filing an incomplete tax return.
Bring in your returns without deduction and we will give you tools to help you keep track, education on what to do and file an amended return and get you that tax you should not have paid back!