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, etc., 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.
People, of course, when they come to us for the first time, have come from somewhere else. They left the CPA, or they used to be a do-it-yourselfer with TurboTax, they decided not to go back to H&R Block, etc. They went somewhere else and have decided to do something different and decided to give our firm a try. When we ask for the copy of last year’s returns, we often see a schedule C business, not incorporated, simply run as a personal business on a personal return, with unbelievable amounts of phantom income.
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 business consultant, a retired teacher from a school district helping 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 22% 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, 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 with 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 preparers that didn’t want to force the conversation and say “no” to filing an incomplete tax return. With the new Trump tax code businesses have a lot of new learning to do as well. Things like entertainment and certian types of meals are no longer deductable in 2018, but 20% of both real and phantom income are. In any case, paying on 80% of income that isn’t really profit…isn’t a good idea!