First, let’s say upfront that a business that has sources of income and expenses and leaves 25% profit on the table is an awesome business! Example: A Plumber makes $400,000 a year and spends $300,000 a year on plumbing tools, trucks, repairs, staff, insurances, and walks away with $100,000 at the end of the year that he can put in his pocket; great business!
It would be rare that it’s that easy. More likely, he puts $60,000 in his pocket and sneaks a few personal expenses into his plumbing books. In a very rare case in the other direction, 50% in expenses and 50% profit, but he probably wouldn’t do that every year. That would be a “magic year” with no repairs to fleet vehicles, no staff turnover, and to have every job bid go perfectly.
Why am I giving you all these examples of businesses, good, more likely, and fantastic? Just to put a framework around phantom income, because we see phantom income reported like other tax preparing firms every year.
What is Phantom Income - And How Does it Happen?
Generally the deposits of a company are accurately reported, because they get sent 1099s from their completed jobs/clients. 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 is almost always right.
The problem is, sole proprietors don’t always know how to properly categorize and document - nor do they even think about- which expenses were a business expense rather than a personal expense. 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 from a retired teacher who helps a struggling school district to set up new management and work flows as an independent contractor, gets a 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 $58,000 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.
It's what our tax planning firm sees 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. 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 to Google and look how much average percentage of profit an owner of a restaurant makes. How much profit does the owner of a tire store make? You won’t see 100% profit, or even 50% profit. Industry averages of Fortune 500 companies are much smaller. When you see it happen on a personal tax return, beware of phantom income.
Most of the time it is deductions that make phantom income go away. They’re legal, they’re applicable, and they’re so often completely missed.
Bring in your returns without deductions 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!