Tax advisory: Income shifting and entity planning
Tax advisory - Income shifting and entity planning Vertical

7 strategies for income shifting and entity planning

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One of the primary motivations many small business owners have to work with a tax and accounting professional is to reduce their tax burden. Income shifting and entity planning are strategies to accomplish this.

Income shifting is not a new concept. It has been used for decades. However, with the explosion of social media, some strategies are becoming more widely known, so it is important that as tax professionals we educate ourselves on the correct way to go about it.

Income shifting involves the transfer of money (legally) within a business or between family members, with the intent to decrease tax liability or adjusted gross income. The primary goal of income shifting is to move or shift a client’s income from the highest bracket to the lowest. 

Here are some of the various options you have for employing this strategy:

#1: Hiring the owners’ children or parents to work in a business

If you advise clients to employ their kids or parents, remember that they must act as bona fide employees and perform legitimate work-related services for the business at wages that are reasonable, and that the appropriate payroll forms will have to be completed.

    By hiring their children, business owners can deduct their salaries from their business income. This allows the client to “shift” business income to their child’s lower tax bracket. Going this route can provide significant self-employment tax and ordinary income tax savings.

    In addition, they can claim a dependent if they have a spouse, partner, child, step-child, adopted child, foster child, younger sibling, elderly parent, grandparent, in-law, or another person who lives in the client’s household and for whom they are financially responsible.

    While this can certainly result in a lower tax liability, there are some valid reasons for not taking this route. The work you assign to your family member must be directly related to your business. In addition, you must pay them a reasonable wage for the duties they perform. Otherwise, it can trigger a reasonable compensation issue. As with everything in tax, make clients document their support for the wages claimed!

    #2: Using the Hope or Lifetime Learning Credits

    If you have clients with dependents who have taxable income from work or investments, and they are students, you may want to consider dropping them as dependents from the client’s tax return. It is possible, depending on a client’s income, that you are losing the benefit of their children’s dependent exemption, anyway. Alternatively, if the client does not claim them as dependents, they can then claim the education credits on their individual income tax returns. To claim themselves, the dependent has to have provided more than half of their support during the year. This support can come from not just employment, but from scholarships and 529 Plan proceeds, if the account is in their name.

    #3: Selling or gifting property and then leasing it back

    If your client is the owner of real estate property, you could use a sale-leaseback or gift leaseback as a tax-advantaged strategy to obtain needed capital or shift income from the client’s higher tax bracket to a family member’s tax bracket, while at the same time adding more tax deductions to your clients’ return.

    A leaseback is a type of agreement where the owner sells or gifts an asset to a buyer/giftee, and then leases that same asset back from the buyer/giftee. Most property used for this type of strategy tends to be either equipment (for the large cost) or real estate (for its appreciated value). 

    If you elect to use this rule, then it is important to take into account the anti-churning rules under Sec. 197(f)(9) that were instituted to prevent taxpayers from amortizing certain intangibles, such as goodwill or going concern value, if those assets were previously held or used by the taxpayer or a related person before Aug. 10, 1993.

    #4: Deferring end-of-year bonuses

    While many anticipate year-end bonuses from their employers, certain scenarios can result in this compensation benefiting the government more than it benefits the client.

    When a bonus is issued, it is considered by the IRS to be “supplemental income,” and as such, is held to a higher withholding rate. Your client will net out less at the time they receive a bonus check, due to the higher tax that is being withheld. In addition, when higher-income earning taxpayers hit certain thresholds in adjusted gross income, they can lose the ability to take certain tax deductions, such as 401(k) deferrals.

    You could suggest that your client request that their employer pay them a productivity bonus on a quarterly or monthly basis, or it could make sense to defer a year-end bonus until the following calendar year. This can be particularly beneficial if you anticipate the client being in a lower tax bracket the following year and/or they will have more losses or deductions that will offset the income.

    However, if the client’s income is expected to increase in the following year, then you will likely want to take that income in the current year.

    #5: Expediting client’s tax-deductible expenses

    As long as your client’s business-related expenses are legitimate, you can deduct all of the business expenses as they pay for them. If you can show that the expense is for the client’s business, and that it is ordinary and necessary, the expense can become fully deductible against their business income.

    Income shifting strategies to reduce tax obligations can be used, such as reducing the amount of income a client has in a given period, by paying large expenses for city or local taxes, estimated taxes, or expenditures on office equipment. If the client has less income, these types of expenses can be deferred until a later date.

    #6: Maximizing retirement plan contributions

    For high-income business owners, retirement planning can be highly effective in reducing taxable income, now and in the future.

    In the present, maximizing contributions to traditional, eligible retirement accounts that enable a tax deduction in the current tax year can help decrease not only income, but potentially downshift your client into a lower tax bracket. It also enables them to access the money at retirement age and pay much less tax on it, to the tune of 12% to 14% by today’s estimates. These accounts may be a SEP IRA, solo 401(k), Roth IRA, or other retirement vehicle. Doing this can also help to reduce a client’s payroll tax obligations because their taxable income is much lower.

    Even if you advise your client to max out their SEP IRA or solo 401(k) now, you can help them further by decreasing their income tax burden in the future with non-retirement accounts so that if your client retires early and wants to begin taking withdrawals from retirement savings, they won’t be subject to any early withdrawal penalties or higher than necessary taxation.

    #7: Entity planning may be the ultimate income-shifting strategy for tax reduction

    If your client is not already an S corporation or C corporation, then it is worth taking the time to conduct an entity planning income calculation to determine the tax advantages of potentially changing their entity type to a more favorable status.

    A reasonable compensation analysis can lead to significant gains in entity planning and income shifting. For example, examining whether your client’s chosen reasonable compensation calculation aligns with the actual work performed can reduce payroll and income taxes, particularly for S corporations or C corporations.

    It’s key to use an impartial source for income calculations, employing accurate benchmarks such as RCReports. Equally important is preparing defensible calculations, rather than relying solely on self-determined figures, in the event of a client audit.

    Wrapping it up

    These are just some of the ways in which you can reduce your clients’ tax burden with income shifting and entity planning. There are many different strategies in this area available to help clients keep more of their hard-earned income including these provided as an additional resource. As a trusted advisor, you can suggest the ones that will provide the most benefit and potentially create additional revenue opportunities for your firm in the process.

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