TL;DR: Taxable income you have to report even though no cash arrived — classic with PIK loans and debt bought or issued below face value.

Private credit is full of loans where interest is PIK (“payment in kind”): instead of paying cash, the borrower adds the interest to the loan balance. For tax, that unpaid interest is generally original issue discount (OID), and a holder must include OID in income as it accrues — cash or no cash.

The result is phantom income: the fund's LPs get K-1s showing interest income, but no distributions to pay the tax. Funds handle this with tax distributions in the LPA, and tax-exempt LPs are usually fine (interest isn't UBTI unless debt-financed). The related cousin is market discount on loans bought cheap in the secondary market, which is generally taxed as ordinary income when the loan is repaid or sold, unless you elect to include it currently.

Phantom income on a PIK loanYear 1: $1.2m taxable interest, $0 cash. Year 2: $1.34m taxable, $0 cash. The loan balance grows instead.Year 1taxable incomecash received$1.2m$0Year 2$1.34m$0Loan balance grows:$10m→ $11.2m→ $12.54m
Income on paper, nothing in the bank.

Worked example

A credit fund holds a $10m PIK note at 12%. Year 1: $1.2m of interest is added to principal and taxed. Year 2: interest is 12% of $11.2m = $1.344m, again added and taxed. Two years, about $2.5m of taxable income, zero cash — until the loan is repaid.

Where you'll see it: OID schedules, K-1 interest income vs. distribution reconciliations, and tax distribution clauses in the LPA.

Code: IRC §§ 1272–1278 · Related: Schedule K-1 (and K-3), Season-and-sell, UBTI

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This glossary is general information, simplified for learning. It is not tax, legal or investment advice, and real structures turn on facts and documents not shown here.