Income shifting is the practice of moving unearned income from one taxpayer to another. Ideally, it moves to someone in a lower tax bracket so the tax bite taken out of the money isn’t as great.
This tactic isn’t new. Wealthy taxpayers and corporations have been making use of it for years. It’s not illegal, although the Internal Revenue Code (IRC) imposes several rules on the practice. Not everyone can meet these rules and requirements, so understanding them is key to shifting income successfully and without penalty.
Definition and Examples of Income Shifting
Income shifting involves redirecting a stream of income, such as from an investment or a business. It moves from you to another individual who will not pay a high tax rate on it. You’re actually giving them your income, so the practice is most common among family members.
The top dollar of your income might put you in the highest tax bracket, which is 37%. You’re expecting to receive income from an investment at year’s end, or maybe you’re self-employed and having a banner year. In any case, you’d have to give 35 cents of every dollar of that money to the IRS because of your tax rate.
Meanwhile, your elderly mother is in the 12% tax bracket, and she’s unable to make ends meet on her own. Income shifting involves transferring that income-producing investment into her name so it’s only taxed at 12 cents on the dollar. You normally help her out financially anyway, but you won’t have to share that income with the federal government as well if you use this method of generosity.
- Alternate name: Income splitting
How Does Income Shifting Work?
Income shifting doesn’t work with earned income, that which is paid to you by an employer or as an independent contractor. Those payments are tagged with your Social Security or tax ID number from the onset. They’re reported to the IRS as your income on Form W-2 or Form 1099-NEC. You’re free to give the money away, of course, but it will first be taxed at your own tax rate.
Only unearned income can be shifted.
Types of Income Shifting
You can shift income a few ways. They all involve giving someone else a portion of your money in a documented way that establishes it as their own.
Hire a Family Member
You can hire your child or children to work for you if you have your own business. Rather than keep that money and be taxed on it at your own rate, you can pay it to them and claim a business deduction for their wages or salary. This also reduces your income for purposes of the self-employment tax if you’re a sole proprietor. Children under age 18 who are employed by their parent’s sole proprietorship or partnership aren’t subject to FICA taxes, either—Social Security and Medicare taxes.
This option isn’t reserved only for your kids. You can hire a parent or a sibling, too. Income you pay to any employee is technically shifted from you to them, but you can keep it in the family when you pay a family member.
Transfer Income-Producing Assets
You can also transfer ownership of an income-producing asset such as company stock to another taxpayer. This might be an investment account or even a rental property. They would report the income on their own tax return and pay their own, lower, tax rate on it. Of course, it no longer adds to your net worth, either—another reason why this tactic is typically used among family members.
You might consider transferring the asset into a trust for the benefit of your child if they are still a minor. This would have the same income-shifting effect because the trust, not you, now owns it.
Defer Bonuses and Income
This strategy doesn't involve giving money away. It's a matter of delaying it.
Taxpayers can shift income from one tax year to the next. This can be advantageous if you’re in a particularly high tax bracket this year but you expect your income will be less next year. You’ll also pay less of a tax percentage on the money if you delay taking year-end bonuses from your employer until January.
You can employ a similar tactic if you’re self-employed. You might delay invoicing or collecting income from a client in November or December and do so in January instead. Or you might pay tax-deductible expenses in December rather than in January, which would also reduce your taxable income in the current year.
You’re actually shifting income to yourself when you delay or defer bonuses and income, rather than shifting it to someone else.
Disadvantages and Restrictions When Shifting Income
Numerous tax rules and regulations restrict these income-shifting measures to some extent.
The ‘Kiddie Tax’
You might still end up paying a tax on income-producing assets that are transferred to your children under some circumstances. So your income-shifting efforts could turn out to be for naught. Congress put the “Kiddie Tax” in place to prevent the transfer of particularly lucrative assets in this way. You won’t get the tax bill for the investment—your child will—but they’ll be taxed on it at your highest tax rate, not their own.
You’ll dodge the Kiddie Tax if you employ your child because the tax only applies to unearned income.
Limits apply to the Kiddie Tax rule, however. The tax only applies to unearned income over a certain amount: $2,200 for the 2021 tax year if your child is any of the following:
- Younger than age 18
- 18 years old at the end of the tax year and you did not have earned income that was more than 50% of the child’s support needs
- Age 19 through age 23 and the child didn’t have earned income equal to more than half of their support needs
The Uniform Transfers to Minors Act (UTMA)
This rule doesn’t apply at the federal level, but some states impose it. UTMA and the Uniform Gifts to Minors Act (UGMA) prohibit securities from being registered in the name of a minor child. You’d have to gift your child this type of asset under UTMA or UGMA rules, or place it into a trust for their benefit.
Placing it into a trust can be tricky as well. The trust’s income still is taxed to you if the trust is a revocable grantor trust. The only way to remove yourself from the ownership and tax equation is to place the asset in an irrevocable trust.
The Gift Tax
You might additionally be hit with a federal gift tax if you transfer an asset to your child—or to anyone else, for that matter. The IRS imposes a tax on gifts exceeding $16,000 per person per year, as of the 2022 tax year. You would owe a gift tax on $4,000 if you give your child or other family member an asset valued at $20,000. The donor is responsible for paying this tax, not the recipient.
You can defer this tax to be payable by your estate at the time of your death if you believe that the total value of your estate will fall below that year’s gift and estate tax exemption. The exemption is set at $12.06 million for individuals as of tax year 2022, but could potentially drop back significantly in 2026 after the Tax Cuts and Jobs Act (TCJA) expires, or sooner if Congress lowers the exclusion rate.
Your Child's Job
Income shifting won’t work unless you legitimately hire your child or family member for a bona fide job opening. In other words, they must honestly perform work for your business in some reasonable capacity. It’s recommended that you have them fill out a time card and other appropriate employment-related documentation. Avoid the temptation to pay them $75 an hour to sweep your floor. Your child’s wages or salary must be on par with what anyone else would receive for performing the same job.
Your Method of Accounting
The option of delaying income into the next year or accelerating tax-deductible expenses only works for self-employed persons who use the cash method of accounting. This method assigns income and deductions to the year in which money is received or expenses are paid. Otherwise, it’s assigned to the year in which you contracted the job or incurred an expense, if you use the accrual method.
- Income shifting is a tactic of moving unearned income out of the ownership of one taxpayer and into that of a taxpayer in a lower tax bracket.
- Income shifting is commonly employed among family members because you’re technically giving away income or income-producing assets.
- The practice is perfectly legal, but the Internal Revenue Code imposes many rules and regulations for doing it correctly.
- You could be hit with a gift tax or your child could be liable for the Kiddie Tax if the asset you give away is very valuable.