Income shifting has been around for many years, and wealthy taxpayers have used it for several years. You can use income shifting to protect your income from tax deductions legally. Accounting for income shifting can reduce extra deadweight loss in personal taxes by around 80 percent.
Being able to create more cash flow from your income is the key to building actual wealth. A great way of accomplishing this is by a financial concept called income shifting.
Income Shifting Definition
Income shifting can be defined as a transfer of income within a business to decrease tax liability or gross income. Provided you stay within the IRS guidelines, you can lower your gross income tax burden by income shifting.
Income shifting moves from you to another individual in a lower tax bracket. This means that you are technically giving them your income, and this makes it more common amongst family members.
How Does Income Shifting Work?
To understand how income shifting works, it is essential to understand the different types of the income usually earned.
- W-2 employees earn salaries or hourly wages. If you are a W-2 employee, you basically pay the highest tax rate.
- Business owners and self-employed persons often receive 1099s. If you are self-employed, you typically pay less income than W-2 employees. When you receive 1099, you get hundreds of tax deductions, unlike W-2 employees.
- Individuals whose income comes from investment. If your money makes more money, you typically get the best tax deals. This is because investment income is often taxed at half the rates W-2 employees pay.
As a business owner, you might be in the highest tax bracket, which amounts to 37 percent of your income. You can be in receiving payment from an investment or be self-employed. Either way, you’d have to pay 35% of your income to cover taxes. This means that out of every dollar you get, you pay 35 cents to tax due to higher tax bracket rates.
Meanwhile, you could have a relative, a parent, or a family member in the 12% tax bracket and cannot make ends meet. If you practice income shifting to their name, you only pay 12 cents out of each dollar. This is also called income splitting.
Income Shifting in Multinational Companies
Multinational companies operate across many countries in the globe. Every company has different laws and regulations in its business operations, including tax rates and policies. The most common technique used for income shifting for multinational companies is using subsidiaries.
Multinational companies can take advantage of the operations in countries where tax laws are not as strict as their home countries. If these companies shift their profits correctly, they can save a considerable amount of money.
Multinational corporations shift about $1.38 trillion profit into tax havens yearly. This occurs when these companies move income from low tax countries to high tax countries. Profits end up being taxed in jurisdictions with little economic activity.
Your company can achieve tax inversion by merging with foreign companies in low rate jurisdictions then parking profits offshore. Tax inversion is a business strategy used to move income from high to low tax countries. Companies that do this include Pfizer and Apple just to name a few.
Multinational companies can further reduce taxes from local locations to lower tax rate geographical locations. They can also make deals by considering receivables to low tax rate areas.
Ways of Income shifting
The primary purpose of income shifting is to move your income from the highest tax brackets to the lowest. Let us look at the various ways you can practice income shifting:
- Hiring your children to work in your business
Provided your children are legitimate employees, you can hire them in your company for income shifting. This has been a viable tax-saving strategy over the years. By employing your children, you can deduct their income from the business’s income as an expense.
This lets you shift the income to your children’s tax brackets, often much lower than the business’s taxable income. It can provide you with a significant self-employed tax and regular income tax. If you hire your children, they must be bonafide workers with legal work-related services in the business.
The IRS may not believe that your 14-year-old child can assist you in complex responsibilities. However, they can do basic tasks in your business like mowing lawns, trimming the hedges outside your office, filing documents, and answering phones.
If you opt to hire your children, you have to pay them reasonable wages completed in the correct payroll forms. The wage amount has to be considerable to avoid raising red flags with the IRS. Also, remember to have them fill out a time card as evidence of the working hours.
- Avoid claiming your child as dependents on tax returns
Most parents often claim their children as dependents on their tax returns. Sometimes, you can claim a person who lives in your household or a financially responsible person. This can be a partner, a child, a foster child, an elderly parent, or a sibling.
This can lower your tax liability status, but there are several reasons you should avoid claiming your child as a dependent
- You may not be able to claim the lifetime learning credits or hope once they get to college.
This mostly happens when you use education credits as an income-shifting strategy. If your children have taxable salaries from investment or work, consider removing them as dependents on your tax returns. You can end up losing the benefit of your children’s dependent exemption.
- Tax credits can be a drawback too.
The person not being claimed as a dependent can work and warm more than usual. They can be eligible to file taxes, and taxpayers may not be reimbursed for the funds they have spent as care for the individual.
- Child custody problems can cause a tax hold-up.
If another person claims the child as a dependent, like an ex-partner in custody battles, this can hold up your tax process. Before claiming any dependent on tax returns, seek advice from a qualified professional that is well informed about the IRS dependency laws.
- Employing or partnering with your parent in your business
If you own a business, you can hire your parent in your business as long as they are in the lower tax brackets. This can help you reap some tax benefits.
On the other hand, you can also get tax benefits by bringing your retired parents that qualify for a low-income tax bracket. You can give your parent some of your limited partnership, S-corporation, or Limited Liability Companies. Any shares income can flow through their tax returns at a lower rate.
If you remain as the principal stockholder of an S- Corporation, a manager of an LLC, or the general partner of a limited partnership, you still control the company.
- Selling property and leasing it back
Your business might require an office building or a long list of medical equipment, depending on the type of business you have. Acquiring this equipment is very expensive. However, you can use a gift or a sale-leaseback if you own this equipment as a tax advantage strategy.
A leaseback is an agreement where an owner gifts or sells a property to another individual then leases it back from the buyer. Assets often used for leaseback agreements include appreciating real estate and large-cost equipment. This can help you obtain capital and shift income from the highest tax bracket.
- Holding off yearly bonuses
A lot of employees often look forward to their end-of-year bonuses from their employers. However, there are certain instances where compensation may end up benefiting your employer more than it does you.
IRS considers the end-of-year bonuses as supplemental income and has a higher withholding rate. This means that you actually net out less income when you receive the end-of-the-year compensation due to the high tax imposed on it.
Once you earn productivity bonuses on a monthly or quarterly basis, it helps to defer a yearly compensation until the next year. This can be helpful if you anticipate being in a lower tax bracket during the next year. However, if the income is likely to be increased in the next year, you can take the end-of-year bonus.
- Accelerating your tax-deductible costs
From the moment you start your business, you can begin reducing all your practice expenses when you pay for them. If the cost is necessary, it can be deducted against your company’s profits.
This includes expenses like vehicle costs, meals, medical fees, and travel. These expenses you cannot personally deduct can become business deductions of structured correctly. Remember to make the most of the payments in your business.
Restrictions When Shifting Income
There are numerous rules and regulations that restrict some income-shifting measures. They are as follows:
- The kiddie tax
If you transfer income-producing assets to your children in various instances. The kiddie tax has been implemented to prevent the shift of particularly lucrative investments. If you share these assets with your children, they will be taxed.
However, certain limits apply to the Kiddie tax rule. This rule only applies to unearned income over $2,200 if your child:
- Is under 18 years
- Gets to 18 years old at the end of the tax year, and you do not have income over 50% of the child’s needs.
- From age 19-23 and doesn’t have income, that’s more than half of their support needs.
- Uniform Transfers Minors Act (UTMA)
The UTMA and the Uniform Gifts to Minors Act (UGMA) prevent securities from being under the name of a minor. According to these rules, you’d have to place the asset into a trust to benefit them later or gift them the asset.
Placing the asset in a trust can be tricky as the trust’s income will be taxed to you if it is a revocable grantor trust. The only way to avoid the situation is to put the asset under an irrevocable trust.
- The Gift Tax
You can also get federally taxed if you transfer the asset to your child as a gift. IRS imposes a gift tax for purchases over $15000 per child every year.
The gift-giver is often responsible for paying the gift tax rather than the recipient. For example, if you gift an asset worth $20000, IRS would charge you a gift tax of $5000.
- The child’s responsibilities
You cannot shift your income unless you legitimately employ the child or family member for the job. This means that they must work for your business, and you must pay them a reasonable income.
They can always fill out the employment-related paperwork and a time card for their hours. Your child’s wages must be on par with any other employee’s wages. Avoid the temptation to pay $75 an hour for mowing lawns.
- The way you do your accounting
Income shifting in specific ways like accelerating tax deductibles or delaying income only works for self-employed people that use the cash accounting method. The cash accounting method assigns deduction and payment to the next year that cash is received or costs are paid. Otherwise, this will be given to the year you contracted the job.
There are several ways you can use to reduce your tax burden. A good example is income shifting. Income shifting is a money-saving strategy of moving unearned profits from one taxpayer to another taxpayer in a lower tax bracket. It is primarily beneficial for family members as Income shifters give away income or profit-producing assets. It is legal, but the IRS places various rules that control it.
Income shifting can work correctly under certain situations, but not everyone can meet its requirements. You can analyze your situation and gauge whether you can take advantage of an income-shifting opportunity. Before making a decision, make sure you contact a professional who understands the rules well to avoid losses.
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