Those small businesses using partnership or S-Corporation formats issue Form K-1 to the respective owners. When income is assigned to the owner and there is no corresponding cash related to that income, then this income is referred to as ‘Phantom Income’. In effect, it is assigned income for tax purposes without the corresponding cash to pay the tax liability.
Phantom income is taxable earnings assigned to the taxpayer via Form K-1 from pass-through tax entities. Phantom income rarely comes in the form of cash to the taxpayer. It is generally a basis adjustment and requires the taxpayer to include the income as if it were received in cash.