Legal Definitions - income-shifting

Income-shifting refers to a financial strategy where an individual or entity intentionally transfers income or income-generating assets to another person or entity that is subject to a lower tax rate. The primary objective of this practice is to reduce the overall tax liability on that income, as it will then be taxed at the recipient's lower marginal tax bracket instead of the original owner's higher one. This strategy is often employed within families or between related business entities.

Here are a few examples to illustrate income-shifting:

• Family Business Scenario: A highly successful architect, operating as a sole proprietor, earns a substantial income that places her in the highest personal income tax bracket. Her adult child, who is attending college part-time, has very little income. To reduce the overall tax burden on the family's income, the architect legally establishes a separate, legitimate business entity owned by her child to handle administrative tasks for her architectural firm. The architectural firm then pays this new entity a fair market rate for these services. This shifts a portion of the architect's high-taxed income to her child's business, where it may be taxed at a lower rate or offset by the child's business expenses, ultimately reducing the family's combined tax liability.

  This illustrates income-shifting because income that would have been taxed at the architect's high personal rate is legitimately transferred to a related entity owned by her child, who is in a lower tax bracket, thereby reducing the total tax paid on that income.

• Investment Portfolio Scenario: A retired couple has a large investment portfolio generating significant dividend and interest income, pushing them into a high tax bracket. They want to help fund their adult grandchild's future home purchase. Instead of receiving all the investment income themselves and then gifting money to the grandchild, they legally transfer ownership of a portion of their dividend-paying stocks and interest-bearing bonds directly to their grandchild, who is currently working an entry-level job and is in a much lower tax bracket. The income generated by these transferred investments is now reported and taxed on the grandchild's tax return at their lower rate, rather than the grandparents' higher rate.

  This demonstrates income-shifting because investment income is moved from the high-income grandparents to their low-income grandchild, resulting in less overall tax being paid on that specific investment income.

• Rental Property Scenario: A software engineer owns several rental properties that generate substantial passive income, adding significantly to his already high salary. He has a younger sibling who is just starting their career and has a much lower income. The engineer decides to legally transfer a percentage of ownership in one of his rental properties to his sibling. From that point forward, the rental income attributable to the sibling's share of the property is reported on the sibling's tax return and taxed at their lower marginal rate, rather than being added to the engineer's already high taxable income.

  This is an example of income-shifting because rental income is transferred from the higher-earning software engineer to his lower-earning sibling, reducing the total tax burden on the income generated by that rental property.