In our previous post — Four Proven Ways to Cut Your Taxes — we highlighted four areas we focus on when seeking to reduce the amount of taxes our clients owe state or federal taxing authorities: shifting, timing, code, and product. In this post, we take a deeper dive into the technique known as shifting, which involves transferring income or assets from a high-tax-bracket person or entity to a person or entity subject to low or zero taxes.

For example, suppose a portion of your business income is taxed at 37 percent, which is currently the highest income tax rate in the U.S. You hire a teenage son and daughter to work for you over the summer and pay each of them $12,400. As a result, you save $24,800 x 0.35 = $8,680 in federal income tax plus any state taxes as well as potentially any amount you would have been required to pay in self-employment tax on that $24,800. Assuming neither child earns more than $12,400, because of the current tax code, they pay nothing in federal taxes. This is a great way to shift business income you don’t need for yourself to your children.

This example illustrates just one of several shifting techniques that can be used to reduce one’s tax burden. Several techniques are available that can be broken down into the following two areas:

  • Business income: In business, the primary objective of shifting is to reduce personal income tax and, in many cases, pay less in self-employment taxes (Social Security and Medicare).
  • Estate planning: In the context of estate planning the objective is to reduce individual income taxes levied on investment income and capital gains while ultimately reducing or eliminating estate taxes. In this post, we touch lightly on shifting the context of estate planning, while in a future post provide more in-depth coverage of this topic.

Income Shifting in Business

If you own a business, you have three ways to use income shifting to reduce your tax bill:

  • Shift income to a family member who’s required to pay little or no income tax.
  • Shift income from a highly taxed entity to an entity taxed at a lower rate.
  • Shift income to a state with lower income taxes.

Shifting income to family members who pay low to no income tax

Hire your children, your retired parents, or other low-income earning family members to work for you, shifting your high tax bracket income to family members in lower (or zero) tax brackets. This technique is a great way to share a portion of the business’s profits with family members in a way that costs you less (as a result of the tax break) than if you were to just give the same amount of after-tax money to your relatives.

Pro Tip: While this tax-savings measure alone does not put more money in your pocket, it could be used in that way, for example by having your children pay a portion of their own expenses. As a parent, you’re required to cover the cost of essentials, such as food, shelter, and clothing, but you can use your child’s income to cover the costs of their summer camp, music lessons, hobbies, and vacation expenses, so you’re not paying those expenses out of your pocket. Any extra money can be deposited in a Roth IRA, to help cover college expenses or serve as a nest egg for your child.

When using the above technique, keep the following key points in mind:

  • The work done needs to be age-appropriate, and those being paid must keep a timecard to document their work.
  • Those being paid may or may not need to file a tax return, depending on the amount of both their earned and unearned income.
  • Each child can earn up to $12,400 in wages and pay no income tax, because this amount is equivalent to the child’s standard deduction.
  • If the business is a sole proprietorship, it is not required to pay FICA (Social Security) and Medicare if the children are between the ages of seven and 18 years old.
  • If the business is incorporated (for example, S-Corp or C-Corp), it is required to pay FICA and Medicare, but the income tax savings is usually more than enough to cover the cost of these payroll taxes.
  • The total savings is the difference between parents’ rate and child’s rate (plus any savings in self-employment tax under certain conditions).

Hiring your children may bring a couple additional benefits:

  • If your children have taxable income, they may be able to claim the American Opportunity Credit or Lifetime Learning Credit, which you may not be able to claim if your income is above a certain limit. For a child to claim this credit, you cannot claim the child as a dependent, which is probably not that important since the dependency exemption was eliminated under the Tax Cut and Jobs Act (TCJA) in 2018.
  • Children who have earned income can each contribute to a Roth IRA up to $6,000 (in 2020) or the amount of their earnings, whichever is higher. While contributions to a Roth IRA are not deductible, anyone in a zero percent tax bracket can invest money tax-free, and distributions taken after the age of 59½ are tax-free.

Investing young in a Roth IRA can deliver a huge benefit in a child’s future. If an 18-year-old contributes the max amount into a Roth IRA for five years and then stops, and those funds earn an 8 percent return, the investment will grow to over $1 million by the time the child reaches the age of 65. At 12 percent, the investment will grow to over $5 million in that same timeframe.

Granted, this tax-saving technique requires some attention to detail to ensure compliance with a complex tax code that’s subject to change from one year to the next. However, the results are certainly worth the effort and the cost of hiring a specialist to help.

Shifting income to entities in lower tax brackets

One of the main purposes of the Tax Cut and Jobs Act (TCJA), which became effective for tax year 2018, was to lower the corporate tax rate to be competitive with that of other countries. TCJA lowered the corporate tax rate to flat rate of 21 percent. If you are paying a higher percentage on the upper portion of your income from your business, you have a couple options for reducing your overall tax burden:

  • Pay yourself less income and leave more money in the corporation. For example, if the upper portion of your income is to be taxed at 32 percent, you may be better off leaving it (or a portion of it) in the corporation and having that amount taxed at 21 percent instead. The drawback is that if you take this money out of the corporation in the form of dividends later, it may be subject to double taxation — the corporation pays 21 percent tax on the profit, and you pay income tax on the dividends.
  • Convert your sole-proprietorship into an S-corporation. With an S-corporation, you can take money out of the business in the form of wages (subject to personal income tax and FICA and Medicare taxes) and as distributions (which aren’t subject to FICA and Medicare taxes — potentially saving up to 12 percent up to the FICA limit, and 3.9 percent on all of the amounts classified as distributions). You can also use the S-corporation to fund employee benefits for yourself — such as health insurance and pension plans — that are deductible by the business and not taxable to you. This approach has a couple potential drawbacks:
    • The salary you pay yourself must be considered reasonable
    • Taking and reporting less in income could reduce your Social Security benefits at the time of your retirement

Forming and managing a corporation, as opposed to a sole proprietorship, is a complicated undertaking done best with the help of an attorney and accountant. Stay tuned for our series about selecting the right business entity structure for details.

Shifting to states with lower tax brackets

Some states are tax-friendlier than others. For example, several states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) collect no state income tax. Likewise, some states have higher corporate tax rates than others.

Prior to the implementation of the Tax Cut and Jobs Act, federal income tax deductions for state income taxes took some of the sting out of living in states with high income taxes. After TCJA, even after taking advantage of its tax savings, many people in states with high income taxes discovered that they were paying significantly more in federal income tax than they were in years past.

One technique for reducing taxes is to incorporate and operate a business in a lower tax state or establish a domicile in a lower tax state. You need to be careful, though — state tax agencies know all the tricks and are becoming more aggressive in fighting for their share of business and personal income tax.

Shifting income for family income tax and estate planning

Tax savings is often most effective when it is approached as a family affair. Parents in high tax brackets can shift assets to their children to spread out their income and reduce the family’s overall tax burden. This technique is not only a savvy income tax play but can also be effective in estate planning. It can also be extended by transferring assets from grandparents to grandchildren. Transferring assets falls into the larger thinking surrounding gifting.

When transferring assets to children, consider the so-called kiddie tax and tread carefully. The kiddie tax is a rule requiring a child’s unearned income above a certain annual threshold be taxed at the parent’s marginal rate regardless of whether the child can be claimed as a dependent on the parent’s return.

More tax-savings techniques

This post touches on a few key income and asset transfer techniques that can be used to reduce a family’s tax burden. Additional techniques include the following:

  • Partnering with spouse
  • Taking advantage of medical expense programs
  • Changing health plans to health savings account (HSA) plans
  • Maximizing contributions to flex spending accounts
  • Restructuring compensation and entities
  • Using dependent care assistance plans
  • Using management companies
  • Using enterprise risk management plans
  • Leasing companies
  • Using low interest loans
  • Using accountable plans
  • Using private foundations
  • Using charitable foundations, donor advised funds, and charitable remainder trusts

Prior to implementing any of these tax-savings techniques, consult a tax planning expert. The first order of business is to define your objectives, such as immediate reduction of your income taxes, minimizing or eliminating estate taxes, or preparing for a tax-sensitive or even tax-free retirement. After settling on one or more tax planning objectives, you’re well prepared to begin examining techniques for achieving your goals.

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About the Author: Laura Stees, CPA is a Partner and Business Strategist with Stees, Walker & Company LLP — a San Diego, Calif.-based boutique tax consulting firm focused on personalized tax and financial guidance to individuals and businesses.

Disclaimer: The information in this blog post about shifting income to reduce taxes is provided for general informational purposes only and may not reflect current financial thinking or practices. No information contained in this post should be construed as financial advice from the staff at Stees, Walker & Company LLP, nor is this the information contained in this post intended to be a substitute for financial counsel on any subject matter or intended to take the place of hiring an Certified Public Accountant in your jurisdiction. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate financial planning advice on the particular facts and circumstances at issue from a licensed financial professional in the recipient’s state, country or other appropriate licensing jurisdiction.