Income Splitting and Income Shifting: Tax Planning for the Self-Employed
What is income splitting?
Income splitting (also known as income shifting) may be defined as dividing income in a way that lowers overall taxes. Typically, income is shifted from higher bracket taxpayers to lower ones. Although there are a number of ways to accomplish this shifting of income, family businesses provide fertile grounds for taking advantage of this tool. One method of income splitting is to hire family members to work in the business; this is perfectly legal. Paying salaries to family members reduces the amount of business income for you to pay yourself. However, you cannot pay your spouse and children an unreasonably high salary, or the IRS will take notice. Another method of income splitting is to give your family members stock in your incorporated business. To maintain control over your business, give nonvoting stock only.
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 generally in a higher tax bracket than their children. Congress closed this loophole by enacting certain rules known as the kiddie tax.
Under the kiddie tax rules, unearned income above a specified amount (currently $2,100) is taxed at the parent’s highest marginal tax 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 income be split among family members in a C corporation to reduce overall income taxes?
Gift of stock to child
As mentioned, you can make gifts of stock (preferably nonvoting) to your children to split income. Children who own stock can receive dividends on their ownership interest in the business. But beware of the kiddie tax. If your child is age 18 or over (substitute (1) age 19 or over if your child’s earned income doesn’t exceed one-half of his or her support, or (2) age 24 or over if your child is a full-time student and your child’s earned income doesn’t exceed one-half of his or her support), however, and gets dividends from the family corporation, the kiddie tax doesn’t apply. The child may be taxed at a lower rate than the parents, thereby lowering the family tax bill as a whole.
Providing fringe benefits to your family employees is another method of income splitting. An employer can provide certain types of fringe benefits to its employees on a tax-free basis while deducting the cost of these fringe benefits. Shareholder-employees of C corporations may qualify for the exclusion of these fringe benefit items from income. Self-employed people (i.e., sole proprietors and partners) generally are not entitled to exclude fringe benefits from income, because the exclusion is limited to employees, and a sole proprietor or partner is not considered an employee for this purpose.
Some fringe benefits excluded from the gross income of employees of C corporations include:
- Qualified employee discounts (such as reduced sale prices for products and services sold by the employer)
- The value of any on-premises athletic facilities provided and operated by the employer
- Working condition fringe benefits (such as use of a company vehicle for business purposes)
Salaries are another way to split income. A corporation is allowed a deduction for ordinary and necessary trade or business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered. But if a shareholder-employee or his or her family member is paid an excessive amount of compensation relative to the services provided, the IRS can disallow a deduction to the corporation for the excessive portion and treat it as a dividend to the shareholder-employee.
How can income be split among family members in an S corporation to reduce overall income taxes?
S corporations can be used to split income among family members to help reduce income taxes. If a sole proprietor wants to retain control of his or her business while splitting the income from the business, he or she may achieve this by setting up an S corporation. In S corporations, income flows through to the owners.
Gift of stock
Income can be split after the S corporation has been established. Shares of stock can be gifted to a family member. The initial distribution of shares to a relative would be classified as a gift; the annual income from the gift would be reported on the family member’s individual Form 1040 return and be taxed at the relative’s tax rate. But beware of the kiddie tax. If your child is age 18 or over (substitute (1) age 19 or over if your child’s earned income doesn’t exceed one-half of his or her support, or (2) age 24 or over if your child is a full-time student and your child’s earned income doesn’t exceed one-half of his or her support), however, and gets unearned income from the family S corporation, the kiddie tax doesn’t apply. In this way, the total tax burden would be distributed among the shareholders, and, very likely, the average tax rate would be less than that of the former sole proprietor.
Howard has a sole proprietorship business that generates net income of $500,000 per year. He decides to incorporate the business and make an “S election.” Howard makes a gift of 10 shares of stock (representing 10% of the business) to two of his relatives–Emily and her husband, Bob. Emily and Bob have taxable income of $20,000 before inclusion of their share of the S corporation income ($50,000). Thus, their total taxable income comes to $70,000.
Bob and Emily would be in the 15% tax bracket and file jointly. Therefore, they would pay approximately $9,568 in income tax in 2017 (assuming no other variables and ignoring any potential application of the AMT). Howard would be in the 35% bracket and would pay significantly more. Thus, gifting to relatives might be a wise idea.
Salaries can also be used to split income. As with C corporations, however, compensation must be reasonable. Some of the factors the IRS will look at to determine whether compensation is reasonable include the following:
- The shareholder-employee’s qualifications and role in the company
- The services actually performed by the shareholder-employee
- The prevailing compensation rates in the corporation’s industry for similar services
- The size of the business
- The degree to which the shareholder-employee contributes to the success of the business
In determining whether total compensation to a shareholder-employee is excessive, bonuses, fringe benefits, and contributions the corporation makes to qualified retirement plans on the employee’s behalf must also be considered. If the total compensation is excessive, a portion of the corporation’s deduction for contributions to its qualified retirement plan on behalf of the shareholder-employee may be disallowed.
How can income be split among family members in a partnership to reduce overall income taxes?
Family limited partnership (FLP)
Limited partnerships can also be used to split income taxes. A family limited partnership (FLP) is owned by family members and operates under the rules of a limited partnership. Typically, parents form an FLP and transfer their assets, such as an existing business, to this entity. Or, a business can be formed as an FLP from the start.
Children as limited partners
An FLP is often used to shift present business income to lower-bracket family members. The parents are named as the general partners, and the children are the limited partners. In other words, the children have no right to manage the business — they are treated like investors who have an ownership interest in the business only. Each child can receive a limited partnership interest worth $28,000 each year (in both 2016 and 2017; $14,000 from each parent) as gifts without federal gift and estate tax consequences to anyone (though there may be state gift tax consequences). Gift and estate tax imposed on gifts in excess of the annual gift tax exclusion may also be offset by your applicable exclusion amount to the extent that is available. In addition, limited partners can work in the business and be compensated for their services.
Technical note: The annual gift tax exclusion is indexed for inflation.
If you make gifts of interests in a family partnership to family members, allocations of partnership income (this does not include compensation for services they provide to the partnership) to such family members is not permitted unless capital is a material income-producing factor in the partnership. Even if capital is a material income-producing factor, special rules may restrict the amount of income that can be allocated to such family members.
Beware of the kiddie tax. If your child is age 18 or over (substitute (1) age 19 or over if your child’s earned income doesn’t exceed one-half of his or her support, or (2) age 24 or over if your child is a full-time student and your child’s earned income doesn’t exceed one-half of his or her support), however, and gets unearned income from the family partnership, the kiddie tax doesn’t apply.
Tip: It is also possible to minimize Social Security payroll/self-employment taxes by restructuring your business entity.