Phantom Income Haunts Taxpayers


As if income-oriented investors don’t have it bad enough in these days of low interest rates, now they may have to worry about paying tax on “phantom” income.

Just ask Joe Miskit. The 89-year-old Laguna Woods retiree owns preferred stock that’s supposed to pay an annual dividend of about 8%. But the issuer--a subsidiary of utility owner Edison International--suspended dividend payments in early 2001 after suffering massive losses during the energy crisis. Edison has since resumed paying dividends on most of its preferred stock, but the issue Miskit owns is an exception, company officials said.

When Miskit started preparing his 2001 tax return, he got socked with more bad news: The preferred stock dividends that Edison didn’t pay continued to accrue. His broker issued a Form 1099 that included this unpaid income and explained why it may be taxable even though it wasn’t received.


“I feel this is so unjust,” Miskit said. “If the company needs to defer paying the dividends, fine. But don’t tax us on it. We may never get it.”

Unfortunately, Miskit is not alone. Statistics on how many individuals pay tax on unreceived income are hard to come by. But many taxpayers could become acquainted with phantom income, especially this year, said Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor in Miami.

That’s mainly because corporate bond defaults soared in 2001, rising to 164 issues worth $93 billion, from 126 issues worth $35.2 billion the year before, he said.

Default statistics aren’t available for preferred stocks. However, largely because of defaults by a few big utilities that issued preferred stock, these also could be pushing record levels, experts said.

Cash-basis taxpayers--that’s virtually all individuals--don’t have to pay income taxes on interest they haven’t received. However, there’s an exception for certain types of bonds and preferred stocks.

The most common exception is interest accrued on zero-coupon bonds. These bonds are sold at a discount, but mature at face value. The difference between the purchase price and the face value is considered interest. Although holders of zero-coupon bonds won’t receive this interest until the bond is either redeemed at maturity or sold, they must calculate how much interest is accumulating on the bond each year and pay federal and state income tax on that amount.

Increasingly, preferred stocks are being treated the same way. Most preferred stocks sold today are structured more like bonds than stock. That provides some tax benefits to the companies that issue these securities, but it puts investors who hold defaulted preferred shares in a tight squeeze at tax time, said George von Zedlitz, vice president of fixed-income investments at Charles Schwab & Co. in San Francisco.

Technically, it works this way: If a company gets in a bind and is unable to pay dividends to its preferred shareholders, it is allowed to suspend those dividends for as long as five years.

During that period, the company--on paper--continues to record “dividend payments.” But those “payments” go into a captive trust that accepts corporate IOUs instead of cash. The company ends up with a tax deduction without the corresponding cash expense--a particularly large benefit to a company in financial trouble.

But this method of accounting also means shareholders must pay tax on that phantom income, von Zedlitz said.

If the company later resumes paying preferred shareholders, the tax issue eventually evens out. The investor has simply prepaid the tax on dividends that would be received in a “catch-up” payment later.

But if the dividends are never paid, investors lose out. Although they can claim a capital loss for paying tax on the dividend payments they never received, that write-off usually is worth less than what the shareholders already paid in taxes on the dividend income at their ordinary income tax rates. (Ordinary income tax rates can exceed 38%, while the top capital gains rate is 20%.)

Sometimes investors get phantom income even when it’s likely that the interest or dividends will never be paid. In those cases, although you may need to report the phantom income, you should write it off as a loss on the same year’s return, Lehmann said.

Lehmann said he had to do this when the issuer of a zero-coupon bond he owned went into bankruptcy protection but continued to accrue interest owed to bondholders.

Just because you get a Form 1099 from your broker saying you owe tax on phantom income doesn’t mean it’s correct, Lehmann said. “You have to look at the nature of the security.”

Tax accountants caution that you should always declare any income that’s on a 1099 on the appropriate line on your tax return. IRS computers match what your brokerage firm said it paid you to what you declared on your tax return. If there’s a discrepancy, your return will be singled out for further review.

“Always give the computer what it wants,” said Vicki Mulak, enrolled agent at American Financial & Tax in Tustin. But if you’re confident you’ll never see the cash, you can subtract the unreceived income on another line of the capital gain and loss form, the Schedule D.

Generally speaking, the IRS does not require proof of a bad debt or capital loss when you file your tax return. However, taxpayers should maintain good records. If you’re audited, those records can help substantiate your position. The IRS may or may not agree in the end, but at least you won’t face onerous negligence or fraud penalties later.


Times staff writer Kathy M. Kristof, author of “Investing 101" (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof For past Personal Finance columns visit The Times’ Web site at /perfin.