Tax Planning - Income-Shifting Strategies

Posted on June 25, 2024

INCOME-SHIFTING STRATEGIES

Income-shifting, also known as income splitting, is a tax planning technique that transfers income from high to low bracket taxpayers. It is also used to reduce the overall tax burden by moving income from a high to low tax rate jurisdiction.

Income-shifting strategies work by changing:

• WHERE income, deduction, or loss is recognized; and
• WHO recognizes the income, deduction or loss.

These strategies work by exploiting the differences and exploring where exactly do they exist- for example, there could be different tax rates across jurisdictions (state, local, or foreign countries) and maybe by shifting taxes from the entities (corporations) to the owners.

TRANSACTIONS BETWEEN JURISDICTIONS (Where)-ALSO CALLED TRANSFER PRICING

• A common form of income-shifting strategies works by advantageously choosing where income or expense is recognized.
• As a general rule, effective tax planning entails recognizing income in jurisdictions with lower tax rates.
• Although recent tax law changes have eliminated a lot of income-shifting opportunities between countries, opportunity still exists for income-shifting between states, as many states have different tax-rates.
• Some states have low(or no) corporate income tax rates, which provides incentive to shift more corporate activity into those states.
• The differences in rates can influence corporate expansion decisions into new states.

TRANSACTIONS BETWEEN CORPORATIONS AND THEIR OWNERS (Who)

• Another type of income-shifting strategy occurs between corporations and their owners and pertains to who recognizes income.
• In general, effective tax planning involves the taxpayer with the lowest marginal tax rate recognizing income.
• In the context of corporations, common strategies include paying a salary to corporate shareholder-employees.
• This often allows the corporation to circumvent double taxation and realize a deduction for compensation.
• The shareholder must only recognize income at his or her marginal tax rate.
• Corporations will often rent property from shareholders or receive loans from shareholders to create a deduction at the corporate level while generating income only once in the form of rent or interest. 
• This can also circumvent double taxation of these funds.
• Aside from simple tax-planning strategies to proactively produce tax savings, corporations must also be aware of potential risks to effective tax planning posed by the contribution or distribution of non-cash property.
• These types of transactions can create adverse tax consequences by generating unexpected tax liability for the shareholder and the corporation.
• In the case of contributions of appreciated noncash property, the contributing shareholder must recognize a gain if the 80% control requirement for Section 351 nontaxable transfers to a corporation is not met.
• In the case of nonliquidating distributions of appreciated noncash property to shareholders, the corporation must recognize a gain on the property distributed to the shareholders (owners).

To summarize, these rules generally discourage the contribution of appreciated noncash property to a corporation when Section 351 deferral requirements are not met (meaning, not having at least 80% control of the company that you are forming, in order to make it a non-taxable transaction).

Also, these tax laws generally discourage the distribution of appreciated noncash property, such as, buildings, inventory, etc., from a corporation for tax purposes, because that would involve paying taxes by the shareholders/ owners of the company.