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What is income shifting, and how can it reduce my tax burden?

The ability to create more cash flow from the money you already make is a key step towards building true wealth. One way to accomplish this is through a strategy known as income shifting. 

Income shifting is not a new concept. In fact, this strategy has been used by the wealthy for generations to help with legally sheltering their income from taxation.

Income shifting is defined as the transfer of money within a business or between family members with the purpose of decreasing tax liability or adjusted gross income. Although it might initially seem a bit sketchy, it is a legal method for lowering your tax burden provided that you stay within IRS guidelines. In order to understand how income shifting works, it is important to first take a closer look at the different types of income that are earned.

- If you’re a W-2 employee and you earn a salary or hourly wage from an employer, you’ll typically have to pay the highest tax rate.  

- Business Owners or self employed individuals who receive 1099s will generally pay less in income tax than W-2 employees. If you receive a 1099, you are essentially allowed hundreds of business tax deductions unavailable to W-2 employees. 

- If you instead earn the bulk of your income from investments – where your “money makes more money” – you actually have the best deal of all as it pertains to taxes. That’s because investment income is typically taxed at only about half the rate of W-2 income.

The primary goal of income shifting is to move, or shift, your income from the highest bracket to the lowest. Let’s look at the various options you have for doing this.

The income shifting methods:

Hiring your kids to work in your business

Hiring your kids to work – provided that they are legitimate employees in your business – has actually been a viable tax-savings strategy for many years. But now with the new tax laws in place, doing so can be even better. 

Why?

By hiring your children, you can deduct their salaries from your business income as a business expense. 

You are able to “shift” business income to your child’s tax bracket, which is typically much lower than yours (unless you earn little or no income). So, going this route can provide you with significant self employment tax and ordinary income tax savings.

Keep in mind:

- If you do hire your kids, they must act as bona-fide employees and perform legitimate work-related services for your business. It’s doubtful that the IRS will believe that your 13-year-old will assist you in the operating room on a patient. However, it is probable that your child could answer the phone, file documents, or even cut grass and trim the bushes outside of your office building. 

- The wages you pay your child must be reasonable and the appropriate payroll forms will have to be completed.  The compensation that you pay your child needs to be considered reasonable in the eyes of the IRS. For example, paying your child $70 or $80 per hour to dust and vacuum the office could raise a red flag. 

- It’s probably best to have them fill out a timecard as proof of the hours they’re working for you.

Read more about hiring your kids in this dedicated Tax Tip Tuesday.

Not claiming your child (or children) as dependents on your tax return

Many parents are in the habit of automatically claiming their child (or children) as dependents on their tax returns. 

In most cases, you can claim a dependent if you have a spouse, partner, child, step-child, adopted child, foster child, younger sibling, elderly parent, grandparent, in-law, or another person who lives in your household and for whom you are financially responsible. 

While this can certainly result in a lower tax liability status, there are some very valid reasons for not taking this route.

- You may be unable to claim either the Hope or Lifetime Learning credits for your college-age children.
This may be the case if you’re using education credits as an income shifting strategy. If you fit this scenario and your kids have taxable income from work or investments, then you may want to consider dropping them as dependents from your tax return. Here, it is possible, depending on your income, you are losing the benefit of your children’s dependent exemption anyway. Alternatively if you elect not to claim them as dependents, they can then claim the education credits on their individual income tax returns even if you are the one who has actually paid their college bills.

- Don’t worry about the tax credits, this could be a drawback too.
If the person who is being claimed as a dependent works and earns more than the allowable amount, then he or she could be eligible to file their own taxes, and if this is the case, the taxpayer may not be reimbursed for money that they have spent to care for the individual.

- Child custody issues can result in a tax hold-up. 
If there is another individual who may also claim the child as a dependent – such as an ex-spouse in a child custody issue – this could result in holding up your tax processing. So, before automatically claiming any dependents on your tax return, it is important to speak with a qualified professional who is knowledgeable about IRS dependency laws.

Hiring or partnering in your business with your parents

Don’t forget about Mom and Dad!

As a business owner, you could also hire your parent or parents - provided that they are in a lower tax bracket - and reap some tax benefits.
On the other end of the spectrum, you could also reap some tax benefits by bringing in your parents as partners in the business. This is particularly the case if your parents (or parent) are retired and qualify for a low income tax bracket. 

In this case, you could give a portion of your S-Corporation, LLC (Limited Liability Company), or limited partnership to Mom and/or Dad and any income from their share of the business can flow through to your parent(s) tax return and is taxed at their lower rate(s). By remaining the majority stockholder of the S-Corp, the general partner in a limited partnership, or the manager of the LLC, you can still retain control of the business.

Selling or gifting property and then leasing it back

Depending on the type of practice that you own or operate, you may require a long list of medical equipment or own your office building – neither of which is cheap! 

But if you are the owner of these items, you could use a sale leaseback or gift leaseback as a tax-advantaged strategy to obtain needed capital or shift income from your higher tax bracket to a family member’s tax bracket, while at the same time adding more tax deductions to your 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).

Deferring end-of-year bonuses

While most people look forward to an end-of-year bonus from their employer, there are some situations where this compensation can actually end up benefiting Uncle Sam more than it benefits you! 

When a bonus is issued, it is considered by the IRS to be “supplemental income,” and as such, it is held to a higher withholding rate. So, you’ll actually net out less at the time you receive a bonus check, due to the higher tax that is being imposed on it. In addition, when higher-income earning taxpayers hit certain thresholds in adjusted gross income, they can lose the ability to take certain tax deductions.

If you earn productivity bonuses or call money on a quarterly or monthly basis, it could make sense to defer a year-end bonus until the following calendar year. This can be particularly beneficial if you anticipate being in a lower tax bracket the following year and/or you will have more losses or deductions that you can use to offset the tax. 

However, if your income will be increased in the following year, then you will likely want to take that income in the current year!

Expediting your tax deductible expenses

As soon as you open the doors of your practice, you can start to deduct all of your business expenses as you pay for them. If you can show that the expense is for your business and that it is ordinary and necessary, the expense can become fully deductible against your business income. 

This is the case, even for various expenses like meals, travel, and vehicle costs that you might still have, even if you did not own your practice. Likewise, medical expenses that you may not have been able to personally deduct, can become deductions with the right business structure in place.

Make the most of the expenses available to you!

Benefit from more tax reduction strategies

These are just some of the ways in which you can reduce your tax burden, but there are lots of different strategies available for medical professionals who want to keep more of their well earned income. Years of expert tax advice can be found in our book ‘Advanced Tax Planning for Medical Professionals’

You can learn more about income shifting, as well as the foundation for basic and advanced tax planning. You’ll read real-life examples of medical professionals who saved big just by using these strategies. You’ll also receive exclusive tax strategy resources to help you get started right away.