Income Shifting (What It Means And Why It’s Important: Overview)

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Let’s look at income shifting what income shifting tax strategy means!

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What Is Income Shifting 

Income shifting refers to a tax planning technique where one taxpayer transfers income to another taxpayer with the overall objective to reduce tax exposure.

In other words, a high-income earner may want to transfer income to a low-income earner allowing the two parties to pay less taxes in the aggregate.

Income shifting is also known as income splitting and so these phrases are used interchangeably.

One notable example of an income shifting strategy is when a parent transfers income from investments to a child.

A person may generate income from many different sources and will eventually need to pay taxes on the income earned.

Adopting a proper tax strategy is crucial the more and more money you earn or the income you generate.

Without proper income shifting strategies, you may be leaving some money on the table even though you could have shifted some income around in a perfectly valid and legal way to reduce your overall tax burden.

Income shifting has been around for a long time and wealthy families have used this type of technique to shelter their income for taxes.

Income Shifting Definition

According to Investopedia, income shifting is defined as follows:

Based on this definition of income shifting, we can see that:

• It’s a tax planning technique
• Consisting of the transfer of income 
• From a high to low tax bracket taxpayer

This process is also known as “income splitting” which is also an interesting phrase as you are effectively “splitting” one taxpayer’s income with another.

These strategies can be adopted by individuals or companies.

In many cases, you may see income shifting tactics performed in combination with individual taxpayers and corporate entities like trusts, limited liability companies (LLCs), limited liability partnerships (LLPs), and so on.

How Income Shifting Works

The ultimate objective of income shifting is to reduce the overall taxes paid on the money that you effectively earned.

To make the best use of income shifting plans, you must have a good understanding of the tax laws (or work with professionals who understand them).

For example, a W-2 employee earning a salary or wages by working for an employer will have a high tax exposure and may have to pay at a higher tax rate.

If you own a business or are acting as a self-employed person receiving 1099s, you will pay less taxes than a W-2 employee for the same amount of income earned.

Also, if you earn money through your investments, you will potentially have the lowest taxation as the tax rates on investment income may be more favorable than earned income or business income.

In addition to that, if you understand how different types of companies are taxed or how different jurisdictions have different tax rates, you can find interesting (and potentially simple) strategies to minimize the taxes that you’ll be required to pay.

One example of how a high-income parent (with high tax exposure) can achieve shifting of income is by transferring unearned income to his or her children under the Uniform Transfers of Minors Act (UTMA) or make a gift under the Uniform Gifts to Minors Act (UGMA).

Other ways you can reduce taxation is by selling or giving property and then leasing it back.

A sale leaseback or gift leaseback could represent a tax-advantageous strategy to get some income while at the same time be able to add tax deductions on your income tax return.

When you do a leaseback, the owner of the property will sell it or gift it to another and immediately get a “lease” back giving the owner the right to use the same property.

Income Shifting Strategy 

What are some common income shifting strategies used out there?

One common shifting of income strategy is to have a higher earning family member shift income to a low earning family member.

Small businesses and business owners may choose to hire a family member or relative to work for the business allowing them to pay salaries.

The payment of salary is a tax-deductible expense for the company allowing the company to reduce its tax exposure.

On the other hand, the salary paid to the family member will be taxed as earned income in the hands of the family member (if the income is low or in a tax bracket lower than the company’s, the overall tax exposure can be reduced).

You also have corporate income splitting strategies.

For example, a family business owner can use tax shifting strategies with family members in combination with family limited partnerships or limited liability companies. 

In this context, the business owner can transfer business assets to the family company and then have the shares, units, or ownership of the family company gifted, sold, or transferred into a family trust to achieve a lower tax liability.

Other income shifting tax strategies could be:

• No-interest loans
• Loans below market interest 
• Sale-leasebacks 
• Gift-leasebacks 
• Life insurance purchases
• Annuity purchases 

Income Shifting Benefits

What are the advantages of income shifting?

If you are looking to save money without having to work harder, then you’ll see the most important advantage in income shifting as an individual.

For companies, if you are looking to increase your overall profits, present stronger financial results, and beat your competitors, you may also want to strongly consider techniques for shifting income.

The main advantage of shifting income is that you are able to retain more money by avoiding taxation at a higher rate.

In essence, by using tax laws and various taxation rules to your advantage, you can implement structures allowing you to move your income around in a way that you end up having to pay less taxes and keeping more money in the entities you control or in your pocket.

You may already be aware that large Silicon Valley corporations use these techniques to reduce their overall tax bill by billions of dollars every year.

It’s important that you know how to setup up your income shifts in such a way that you remain in compliance with the law.

There are laws that allow the state to issue fines and penalties if you are trying to avoid paying taxes in unreasonable or illegal ways.

For example, in the United States, Congress has adopted the “Kiddie Tax” rule in an attempt to avoid having high-income parents avoid paying taxes on their investments shifted to their children.

So now, if you want to shift income to your children, you’ll need to make sure you do it in compliance with the legal requirements. 

Tax Inversion Income Shifting

Another strategy used to reduce the overall tax burden is known as tax inversion.

Tax inversion is the process of transferring income from a high tax jurisdiction to a low tax jurisdiction (national or international tax planning).

The difference between tax shifting and tax inversion is that tax shifting is generally done within the same tax jurisdiction and between different local taxpayers whereas tax inversion involves different tax jurisdictions and foreign entities or individuals.

Individuals can achieve tax inversion by transferring assets and income from one taxpayer to another taxpayer in a different state and subject to a different tax rate.

Most of the time though, large corporations are known to use tax inversion techniques such as Apple, Nike, and Pfizer where they transfer their income to jurisdictions offering them lower business income tax rates.

If a company can reduce its overall tax burden by shifting its revenues from one country to another country, it may find ways to incorporate a company in the foreign jurisdiction and then merge with it so it can pass on its revenues to that jurisdiction.

Companies that have a commercial presence in different jurisdictions can also evaluate the possibility of shifting income to the jurisdiction in which they are exposed to pay the least amount of taxes.

In that context, major corporations can shift income to the states, locations, or jurisdictions offering them lower tax rates and move money around within their group of entities through transfer pricing techniques.

Shifting Income Takeaways 

So, there you have it folks!

What does income shifting mean?

Is income shifting legal?

What factors need to be present for income shifting to be a viable strategy?

Income shifting provides you ways to generate more cash flow from the income that you are already making.

In other words, if you earn $100,000 in income and must pay $40,000 in taxes, your net income is $60,000.

With the right income-shifting strategy, you may be able to reduce your tax burden by $10,000 and thus create $10,000 more cash flow for yourself.

Income shifting is not illegal or intended to avoid paying taxes.

Essentially, you are using the law and legal methods to reduce your tax exposure.

Think of it as investing in the stock market.

When you invest in the stock market, you are looking for various investment strategies that will help you generate a good return and minimize your risk (with the ultimate objective to make money).

When you do tax shifting, income splitting, or income shifting, you are studying the tax laws to find strategies that will allow you to generate a better return (by keeping more money that you earned in your pocket).

Good luck with your tax planning!

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Income Shifting Meaning

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