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"Phantom Income" and a Recent Adverse IRS Memo for Investment Account Wrap Fees
Phantom income is tax jargon for income that you are taxed on but that you don't actually receive.  For example, assume you that you earn taxable income of $5 but pay a fee of $3.  If the fee isn't deductible, you've got phantom income of $3 because although you will report $5 of taxable income on your tax return, you only receive $2 in cash (net of the $3 nondeductible fee).


Phantom income can arise with regard to investment activities of individuals because although most investment income (other than tax-exempt municipal bond income) is taxable, investment expenses of individuals are not always deductible due to an overall limitation on certain types of itemized deductions referred to as the "2% floor."  Section 67 of the Internal Revenue Code provides that certain types of itemized deductions are only deductible to the extent that such deductions during the tax year exceed 2% of the taxpayer's adjusted gross income. 

Most, but not all miscellaneous itemized deductions are subject to the 2% floor.  Importantly, an individual's investment expenses generally are.  Thus, investment fees paid by individual investors can result in phantom income because the fees may often not be deductible due to the 2% floor.

Nobody likes phantom income so it is not surprising that taxpayers and their advisors are always looking to see if they can eliminate or minimize phantom income.

In certain cases, an individual may argue that he or she is a dealer rather than an investor because dealer expenses are business expenses rather than investment expenses and therefore are not subject to the 2% floor.  The determination of whether an individual qualifies as an investor, trader or a dealer for federal income tax purposes will not be addressed here.  However, as a warning, qualifying as a dealer can be difficult and it should be noted that there are many tax cases where individuals have lost this argument and have been subject to additional tax liability, interest charges and penalties.

Another way an investor may try to avoid phantom income and the 2% limit could be to treat investment expenses as capitalized as part of the cost of his or her investments.  In order to do this, it must be determined that such expenses are "carrying charges" within the meaning of Internal Revenue Code Section 266.  Section 266 permits taxpayers to elect to capitalize carrying charges.  Here's a simple example that illustrates the idea: assume Investor buys stock for $100 and incurs investment expenses of $10.  Investor sells the stock for $120.  If the investment expenses are carrying charges and Investor elects to capitalize the expenses, and they are added to the investor's basis in the stock, the gain recognized on the sale of the stock would be $15, rather than $20.  Thus, Investor has obtained a tax benefit for the investment expenses because the amount of gain recognized has been reduced.

Unfortunately, on May 25th, 2007, an IRS legal memo (Chief Counsel Advice) was released that holds that certain flat fee investment expenses paid to a stockbroker (such as wrap account fees) were not carrying charges under Section 266 and therefore could not be capitalized under this rule.  The IRS memo is a limited form of guidance, cannot be cited as precedent, only represents the viewpoint of the IRS and has not been court tested so it is not the final word on this issue.  However, it suggests that the IRS disagrees with taxpayers' attempts to avoid phantom income associated with investment expenses by treating them as carrying charges.  Investors should be aware of the IRS view and discuss the potential risks, costs and related penalties with their tax advisors.


DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.