The term “income shifting” has been in existence since the beginning of the industrial era. Many wealthy business owners have been using the strategy to reduce their tax burden for generations. On this post, we will define income shifting and how you can use it to lessen your tax burden. It is one of the best ways to avoid high tax if you understand how it works. Continue reading to learn more about income shifting.
What is income shifting?
Income shifting is the transfer of fund within a business to another member or between family members with the sole aim of decreasing tax liability.
Another name for income shifting is income splitting. It is a tax planning strategy adopted to reduce the tax burden by transferring income from high to low tax bracket individuals.
What is the income shifting strategy?
Income shifting strategy is the plan of actions used to reduce long term tax liabilities. It involves the transfer of income from high to low tax bracket individuals within a business, or from one family member to another.
Let’s assume that Mr A is in a relatively higher tax bracket of 34 per cent. Instead of him paying all his income at that rate, he will give part of it to a family member in a lower tax bracket of 10 per cent. Such a family member can be his employee.
Income shifting strategy helps to save a lot of money in the long run. This is done by adding your children or elderly relatives to your business as an employee. Or by gifting them the money to reduce your income.
Nonetheless, income shifting and lowering of taxes have some structural rules and regulations, so it’s not magic.
Methods of income shifting
Income shifting by hiring your kids to work in your business
This is one of the best ways to utilize the income shifting strategy. Your kids become legitimate employees in your business when you hire them to work. This is method is the best according to the new tax law in place.
Why hire kids as employees? Their salaries will be deducted from your business income as expenses. That will enable you to shift business income tax to your kids’ tax bracket, which is much lower than yours. This strategy will help you to reduce self-employment tax and ordinary income tax.
Things to keep in mind when you hire your kids:
Your kids must act as bonafide employees of your company and perform their duties for your business.
1. It is doubtful that the Internal Revenue Service will believe that your 14-year-old child will assist you in the construction site. Nonetheless, your child can file documents, answer phone calls, or trim the bushes and cut the grass outside of your office building.
2. The wages you pay your kid must be reasonable and he/she needs to fill the appropriate payroll forms. The amount that you pay him/her needs to be considered reasonable in the eyes of the Internal Revenue Service. For instance, paying your child $70 or $90 per hour to dust and vacuum the office would raise a red flag.
3. It is good to have them fill out a timecard as evidence of the hours they are working for your business.
Income shifting by gifting
One of the easiest ways to shift income is by gifting part of it to your family member, which can be your child or parent. The IRS states that an individual can gift up to $15,000 per person every year. The amount to be gifted would increase by the number of children you have, and that will save more income in the long run. Besides, your spouse too can gift that much per child, if he/she wants to take advantage of the income shifting method to reduce the tax burden.
Gifting to your spouse
Normally you can gift any amount to your spouse without having to file a gift tax form. This may be a viable method to shift income if your spouse tax bracket is on the lower end. Nonetheless, we advise that you speak to your tax attorney before employing the strategy.
Gifting to your parents
It is normal to gift money or take care of both parents. However, this can be one of the easiest ways to reduce the tax burden. Elderly people fall in the lesser tax bracket. So, you can gift money to your parent as an income shifting strategy. You should discuss with them and notify your tax attorney before implementing this strategy.
Income shifting is more than gifting cash to your relatives or paying them as employees. You can also gift properties and investment assets to reduce tax liability. As a property owner, you might be required to pay higher capital gain tax. However, your child will pay a substantially lower tax rate on the property if he/she is the owner.
Income shifting by sale-leaseback
A sale-leaseback is a process whereby you sell a property and lease it back to run your business. The sale-leaseback can be employed to reduce tax burden through the income shifting strategy. How can this be implemented? You will sell your property to a family member within the lower tax bracket. This will reduce your tax liabilities and give you the opportunity to continually use the property. Most property employed for this type of strategy tends to be either real estate (for its appreciated value) or equipment (for the large cost).
Income Shifting Between States
Tax rates are different from one state to another. Some states in the United States have a more favorable tax rate than others. A person who operates a business in multiple states can shift income from one with a higher tax rate to one with a lower rate. This method is a bit complicated and requires an extensive business operation, but it’s worth paying attention to if you qualify.
You can also place assets into a non-grantor trust that lives in a state with lower tax. You should talk to your tax attorney about how to set this up to ensure that you do it properly.
Conclusion on Income Shifting
Income shifting is a good way to reduce the tax burden in the modern world. It is highly appealing if you can save 25 to 30 per cent of your income through income shifting strategy. Nonetheless, it is a relatively complex process and you need to understand how it works. Therefore, we recommend you speak to your tax attorney.