Phantom Income in Estates

  • Posted by Bruce McDonald
  • September 16, 2016
  • (0) Comments

“Phantom income” is a term sometimes applied to taxable income you did not know you had, or no one reminded you that you had.  Business owners often see it when they use business income to pay off loans that put capital into the business.  The interest may be deductible, but the principal payment is not. So the owner of a business that had a good year, and paid down its bank loans, can have a big shock when the tax returns are prepared. Phantom income!

Personal representatives, who are personally liable for unpaid income tax obligations to the extent there are estate assets which could have paid the tax, can encounter phantom income, requiring that the estate file a 1041 income tax return and pay taxes on that income, when creditors of the deceased have to write off (i.e.,”discharge” or forgive) the debt, under 28 USC sec.108.

Some credit card companies interpret the statute requiring them to report “discharged debt” to IRS even when it is the incompetence of the credit card company which bars the debt from being collected.  If a credit card company is late filing its probate claim or totally fails to file, even when sent a certified mail Notice to Creditors which invites them to file their claim, the debt is still deemed “discharged” under the law, in the opinion of some creditors.

The creditor who failed to enforce the debt may not send the required 1099-C form to the personal representative until late in the estate administration, even after the twelve months in which Florida law requires completion of the estate unless extended.

This presents a real dilemma for personal representatives in solvent estates when significant creditor claims are not filed or are filed late.  How can they distribute the net proceeds to the beneficiaries when it is possible that one or more 1099-C forms will be sent to IRS, who then will be looking for an income tax return and payment of taxes?

There are no universal or easy answers for this problem.  The only certain result is an increase in administrative expenses, both legal and accounting, plus a major headache for the personal representative.