Christie

What is shifting income/timing income?

Income shifting (also known as income splitting) may be defined as dividing income in a way that lowers overall taxes. Typically, income is shifted from higher-bracket taxpayers to lower ones. Income shifting can be a valuable tool for self-employed persons.

Although there are a number of ways to accomplish a shifting of income, the following methods are most popular: employing family members, family partnerships, interest-free and below-market loans, gifting, sale- or gift-leaseback, trusts, and life insurance/annuities. When using these methods to shift income to a child, it’s always important to bear in mind the kiddie tax.

Timing the receipt of your income can also help you lower your taxes. When tax rates are stable, it’s wise for you to defer as much income as possible from one year to a later year and to accelerate deductions so that you can postpone payment of the tax. When you eventually realize the income at some future point, it’s possible that you’ll be retired and/or in a lower tax bracket. Understanding the differences between the cash method and the accrual method of accounting can also help you to time your income most effectively.

What is the kiddie tax, and what is its relation to income splitting?

In the past, parents found that they could lower their taxes by shifting unearned income into their children’s names. This worked because the parents were in a higher tax bracket than their children. Congress closed this loophole by enacting certain rules known as the kiddie tax.

The kiddie tax rules apply when a child has unearned income (for example, investment income). Children subject to the kiddie tax are generally taxed using the trust and estate income tax brackets on any unearned income over a certain amount. Currently, this amount is $2,200 (the first $1,100 is tax free and the next $1,100 is taxed at the child’s rate). The kiddie tax rules apply to (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support.

How can employing your family members help you to shift income?

One method of income shifting is to hire your family members to work in your business. Paying salaries to family members reduces the amount of business income that you must pay yourself. In addition, the tax code provides a particular Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) tax exclusion for unincorporated businesses that employ an owner’s children. The earnings of a child under 18, who is employed by a parent owning a sole proprietorship or a partnership, are not subject to FICA (Social Security and Medicare taxes). Likewise, there is an exclusion from FUTA (unemployment tax) for a business paying the owner’s child who is under age 21. Of course, you’ll have to ensure that the type of work performed, the rate of pay, and the timing of payment are all appropriate.

How can income be split among family members in a family partnership to reduce overall taxes?

Limited partnerships can be used to split income taxes. A family limited partnership (FLP) is owned by family members and operates under the rules of limited partnerships. Typically, parents form an FLP and transfer their assets (e.g., an existing business) to this entity.

The FLP is used to shift present business income to lower-bracket family members. The children have no right to manage the business; rather, they are treated like investors who have an ownership interest only in the business. Each child can receive limited partnership interests worth $15,000 (the current annual gift tax exclusion amount) from each parent as gifts, without federal gift tax consequences. Thus, income generated by the business will pass through to a number of different family members. In addition, limited partners can work in the business and be compensated for their services. Be aware, however, that the IRS has expressed some concerns regarding the gifting of FLP interests.

How can gifts be used to shift income?

Gifting assets to family members is another way to shift income. It might be advantageous for you to gift income-producing investment assets (such as stock in various companies) to your relatives. The initial distribution of shares to your relatives would be classified as a gift, and the annual income from the gift would be taxed to the relative. You can make federal gift tax-free gifts of up to $15,000 per year per recipient under the annual gift tax exclusion. Married couples can generally double that amount if they split the gifts. If your gift exceeds the annual exclusion amount, the excess may be subject to gift tax. However, gift tax due may be offset by your $11,400,000 (in 2019, $11,180,000 in 2018) basic (applicable) exclusion amount, if it is available.

You should also be aware of the Uniform Transfers to Minors Act (UTMA) and the Uniform Gifts to Minors Act (UGMA). Some states don’t allow securities to be registered in a minor’s name. Basically, if you want to transfer an income-producing asset to a minor child, you have two choices: to make the gift under UTMA or UGMA or to make the gift in trust.

How can interest-free and below-market loans be used to shift income?

Another way for a family to shift income is to use a no-interest or low-interest loan to a family member as an alternative to an outright gift. Low-interest means that the rate of interest charged is less than the applicable federal rate (AFR) set monthly by the IRS. In general, the IRS will impute interest (i.e., treat you as if you had received interest at the AFR) if you loan money without charging at least the AFR. However, there are some exceptions to this rule. In general, de minimis loans (those that are $10,000 or less) will not result in imputed interest or reclassification as a taxable gift. Also, if certain conditions are met, loans of less than $100,000 will not cause interest to be imputed.

How can trusts be used to shift income?

You can transfer income-producing assets or cash into a trust for the benefit of someone else. If the trust is set up properly, income that is paid out of the trust to a beneficiary will be taxed to the beneficiary rather than to you. Thus, the trust may be used as an income-shifting tool. Many different forms of trusts exist, and you must be careful to avoid grantor trust arrangements, whereby trust income is taxed to the grantor rather than to the beneficiary. Grantor trusts usually are not used for income shifting, although they have many other uses.

How can annuities and life insurance be used to reduce income taxes and shift income?

Rather than invest all of your cash in income-producing assets that create taxable income in the current year, you can purchase an annuity to reduce income taxes; this is because the income generated by the annuity will accumulate tax free until the funds are withdrawn. The interest is not taxable in the current year as long as no withdrawals are made. In addition, if the annuity payouts will begin when you are much older, you may be in a lower tax bracket at that time.

You can also invest some of your cash in a life insurance policy, naming a relative as the beneficiary and/or owner. In this way, you can also shift income, and the cash value of the policy grows tax deferred.

How can a sale- or gift-leaseback be used to shift income?

Another way to shift income is to transfer property (such as a vacation home) by using a sale- or gift-leaseback arrangement. Typically, you would sell the property to a relative and then rent it back from the relative. Potentially, the lessor would get depreciation benefits as well as rental income.

What about the timing of income?

Timing your income appropriately can also help you to lower your taxes. Self-employed persons should know the difference between the cash method of accounting and the accrual method of accounting. It is also useful to know about postponing (deferring) income and accelerating deductions.

Cash versus accrual method of accounting

Essentially, using the cash method of accounting means that your business will recognize revenues and expenses only when there is an actual inflow or outflow of cash with respect to your business.

Assume John Smith began a sole proprietorship, the Smith Barbershop, on December 31, 2018. His fiscal year also ends on December 31. Smith has three customers on December 31, and each receives a $20 haircut. Two of the customers pay Smith in cash, and one customer tells Smith he’ll be back with a $20 bill the next day. Smith hands the third customer a bill to remind him of the debt. Because Smith uses the cash method of accounting, he informs the IRS that he earned $40 for 2018.

If, however, John’s business used the accrual method of accounting, he would have to report $60 worth of income to the IRS for 2018. That’s because John completely performed his end of the haircutting contract and is owed an additional $20 for work performed during 2018.

The accrual method of accounting, then, may be defined as one that recognizes revenue at the point of sale and recognizes expenses when incurred (not simply when paid).

Postponing income and accelerating deductions

When tax rates are stable, it’s generally wise to lower your taxable income by postponing your income and accelerating your deductions. For instance, if you’re a self-employed taxpayer who uses the cash method of accounting in your business, you should consider delaying the billing of some of your customers until next year. It’s not taxable income until you have the cash (or a reasonable substitute) in hand.

If, however, you use the accrual method of accounting in your business, you should defer your right to receive payment for the goods or services you provide. You can accomplish this by waiting until next year to finish a job or by holding up your delivery of goods until next year.

You can accelerate deductions by incurring (or paying) deductible expenses late this year instead of early next year.

You don’t want to pay more in federal income tax than you have to. With that in mind, here are five things to consider when it comes to keeping more of your income.

1. Postpone your income to minimize your current income tax liability

By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you’d otherwise use to pay income taxes. And when you eventually report the income, it’s possible that you’ll be in a lower income tax bracket.

Certain retirement plans can help you postpone the payment of taxes on your earned income. With a traditional 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you later withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty tax in addition to regular income tax, unless an exception applies). This allows you to postpone tax on part of your salary and take advantage of the tax-deferred growth of any investment earnings.

There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.

2. Shift income to family members to lower the overall family tax burden

You may also be able to minimize your federal income taxes by shifting some income to family members who are in a lower tax bracket. For example, if you own stock that produces dividend income, one option might be to gift the stock to your children. After you’ve made the gift, the dividends will represent income to them rather than to you, potentially lowering your family’s overall tax burden. Keep in mind that you can make a tax-free gift of up to $15,000 (in 2018 and 2019, and could increase in future years) per year per recipient without incurring federal gift tax.

However, look out for the kiddie tax rules. Under these rules, for children under age 18, or children under age 19 (or full-time students under age 24) who don’t earn more than one-half of their financial support, any unearned income over $2,200 (in 2019, $2,100 in 2018) is taxed using the trust and estate income tax brackets. Also, be sure to check the laws of your state before giving securities to minors.

Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Be sure to investigate all of your options carefully before acting.

3. Deduction planning involves proper timing and control over your income

Part of minimizing federal income tax is about taking advantage of all deductions to which you are entitled, and timing them in the most beneficial manner.

As a starting point, you’ll have to decide whether to itemize your deductions or take the standard deduction. Generally, you’ll choose whichever method lowers your taxes the most. If you itemize, be aware that some deductions (for example, medical expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income (AGI). In cases where your deductions are affected by your AGI, you might look at ways to potentially increase your allowable deductions by reducing your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.

Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to consider accelerating deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.

4. Investment tax planning uses timing strategies and focuses on your after-tax return

You can also minimize tax by making tax-conscious investment choices. Potential strategies can include the use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.

Although income is generally taxable, certain investments generate income that’s exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like a gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you’ll want to focus on those choices that maximize your after-tax return.

In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you’ve held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.

Note: You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.

5. Year-end planning focuses on your marginal income tax bracket

Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it’s December and you know that you’re in a higher tax bracket this year than you will be in next year. If you’re able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.

Shifting Income/Timing Income: Tax Planning for the Self-Employed