If step one in the tax planning process is formulating a tax strategy, step two is often overlooked but equally important: creating an implementation plan. What steps do you need to take to set your strategy into motion? Are there any complex parts of your strategy that will require you to work with outside vendors, file special paperwork, or create new accounts and entities?
One potentially profitable tax strategy that requires a clear implementation plan is income shifting. Income shifting essentially transfers money or assets from taxpayers in a higher tax bracket to those in a lower tax bracket. This reduces the overall tax burden for the high-bracket taxpayer. The most common example is shifting investment income, like stock dividends or property income, from a parent to a child through a trust or as a gift. Similarly, taxpayers can strategically shift income from an entity in a high-tax state to a lower-tax state.
If you are looking to incorporate income shifting into your tax strategy, the next question is what does the implementation process actually look like? There are seven key steps to keep in mind:
1. Determine the Income Shifting Strategy
As mentioned above, strategy development is the first step. This means knowing what your ultimate objective is before deciding that income shifting is the route to take. Where and how will you shift your income? What is the difference you expect it will make in your overall tax savings? How might income shifting affect the other tax strategies you could implement? Defining your objective clearly will help you ensure that this particular strategy will actually succeed.
2. Establish Contracts
Once you are committed to implementing an income shifting strategy, the next step is to establish contracts. When you have multiple entities doing business with each other, you need official contracts in place. This goes back to the arm’s length doctrine: transactions between related parties should be conducted similarly to transactions between unrelated parties. In other words, you wouldn’t walk into a local business where you don’t know anyone and say, “Hey, give me a loan” and receive the money with no documentation. You also would not be able to sell a service to that business for way less than you actually paid for it.
In keeping with the arm’s length principle, you need an official contract, actual records, and an agreement that reflects fair market value. You want to create a legitimate paper trail throughout this process. This means if you are hiring a family member, you still need to keep timesheets. If one entity you own is selling assets to another entity you own, create invoices like you would for any other customer.
3. Establish Record Keeping
Record keeping includes timesheets, invoicing, prorating, allocating expenses, conducting valuations, and using comparables to establish what fair market value is. For example, if we are trying to establish a reasonable compensation for hiring your child, what are we using to determine a fair market value wage for bussing tables? Keep a record of any data and sources you pull to make financial and other related decisions. Depending on your method of income shifting, you might also need a note amortization schedule. This will state the amount of the payments that you need to make monthly to pay for an asset.
Rental agreements are also included in this list. If you have a commercial property that is owned by the taxpayer and occupied by the main business, there should be a lease where the business has signed a commitment to the owner to pay a certain amount on a regular basis. Part of implementing the strategy includes hiring an attorney to create that lease agreement and for any other notes and contracts between companies. A good rule of thumb for when to have an attorney draft a contract is if there is any third party that is not related. So if you have a partner who is not related and the plan is for you to own company A and your partner to own company B, you will want an attorney forming those entities and drafting the contracts.
4. Establish Bank Accounts
The fourth step is establishing bank accounts. In the case of hiring a family member or adding an additional entity, a separate bank account is required.
5. Determine Accounting Responsibility
Now that we have identified which records to keep and what that process will look like, we need to assign these responsibilities to specific people. Who is in charge of what? Work with your tax planner to create a comprehensive list of every ongoing payment or official documentation needed, and make sure a reliable person is assigned to each item.
6. Transfer Ownership of Asset
Depending on the exact strategy, you may need to transfer ownership of an asset. Now that the documentation is in place, you can actually take this step. If you are moving a property from the main entity to the individual owner, you will need to determine the fair market value of the property at this point. To simplify the transfer, you might also consider creating a quitclaim deed, which releases the owner’s interest in the property without stating the nature of their interest or rights to the property.
7. Monitor and Review
Finally, all the initial checkboxes for implementation are complete, and we have arrived at the maintenance stage. At this juncture, you are simply monitoring and reviewing progress on any ongoing responsibilities to make sure everything is getting done. This is the best time to make tweaks, so you are not rushing to adapt your strategy during tax season. Getting ahead of maintenance needs is the best way to ensure each client is getting the maximum possible tax savings and that each client is profitable for you.
Summary
Income shifting is a sophisticated tax strategy, but it is also a fairly common method of minimizing tax burdens for high-income individuals and business owners. As with any strategy, whether it is worth the time and effort to undergo this process depends on your objectives. If you already have the entities, trusts, or family members in place to facilitate this process, all it takes is a clear implementation plan and the help of a knowledgeable advisor to shift income in a way that is above board and fully documented.
For guidance and ongoing support in executing the income-shifting tax strategy, connect with a Certified Tax Planner today.
