Income Splitting

 

 

Progressive tax rates mean that  the more you earn, the more they take. By “splitting” the income among family members, I will pay a lower overall tax because each will be in a lower bracket and lesser absolute dollars will go to the government.
Splitting Income Among Group Members
Lower overall taxes can be obtained by splitting income among members of a group. The next question is, “Who can make up that group?” Such a group can be composed of:
(1) Family members or relatives,
(2) Investors,
(3) Entities (e.g., trusts, partnerships, corporations), or
(4) Any combination of the above three.
There are six major formats for income splitting:
(1) Unincorporated business - sole proprietorship or partnership,
(2) “C” (or regular) corporation,
(3) “S” corporation,
(4) Family partnership under §704(e),
(5) Custodianship under UGMA and UTMA, and
(6) In certain limited instances, an interest-free loan.
Unincorporated Business
Because of tax reform, one of the best tax shelters is your own business. Consider the following tax advantages:
Deductible Business Expenses
For the self-employed, business expenses are deductible in full directly from gross income. On the other hand, employees may only deduct their business expenses when they itemize, and most of these deductions were reduced by 2% of AGI. Now, from 2018 through 2025, all miscellaneous itemized deductions that were subject to the 2% floor are suspended.
Home-Office Deduction
If you operate a business out of your home, a portion of the expenses of your residence may be allocated to the business. However, you must prove that such portion of the home is used exclusively and regularly for business purposes.
Requirements - §280A
1. There must be a specific room or area that is set aside for and used exclusively on a regular basis as:
a. The principal place of any business, or
b. A place where the taxpayer meets with patients, clients or customers in the normal course of your trade or business, or
c. A separate structure that is used in your trade or business and is not attached to your house or residence.
2. An employee can take a home office deduction if he or she meets the regular and exclusive use test and the use is for the convenience of the employer.
3. No deduction is allowed unless there is a trade or business involved.
Non-Exclusive Use Exceptions
Two special exceptions are made where part of a home is regularly, but not exclusively, used for business purposes:

Inventory: A wholesaler or retailer who uses part of a home to store inventory that is held for sale. However, this exception applies only if the dwelling unit is the taxpayer's sole fixed location of the trade or business.

Day Care Facility: Part of the home is used for daycare of children, physically and mentally handicapped persons, or individuals age 65 or older.
Note: Section 280A does not disallow deductions otherwise allowed for tax purposes, like home mortgage interest, real estate taxes, or casualty losses.
Moreover, non home-related business expenses, such as business supplies, cost of goods sold, wages, and operating expenses, are not affected by §280A. Deductible home office expense is limited to the gross income from the home business, reduced by regular operating expenses (wages, supplies, etc.) and an allocable portion of the mortgage interest, property taxes, and casualty loss deductions. Expenses that aren’t deducted due to the income limit in one year can be carried over to future years.
Home Office Deduction Expansion
The TRA ‘97 enhanced the ability of taxpayers who work at home to claim deductions for home office expenses by expanding the definition of “principal place of business” to include a home office that is used by the taxpayer to conduct administrative or management activities of the business, provided that there is no other fixed location where the taxpayer conducts substantial administrative or management activities of the business.
Deductions will be allowed for a home office only if the office is exclusively used on a regular basis as a place of business and, in the case of an employee, only if such exclusive use is for the convenience of the employer.
Example
Doctor Dan consults with patients at local hospitals and uses a portion of his home exclusively and regularly to conduct administrative or management activities. Dan does not conduct any other significant administrative or management function at another fixed location. Dan qualifies for the home office deduction.
Analysis
This expansion restores the office deduction to the vast majority of millions of business people who work out of their home, such as:
(1) Home-based employees who telecommute to the main office,
(2) Doctors who perform their duties in hospitals but need to do their billings from their home office,
(3) Salespeople who call at the customer’s place of business,
(4) Professional speakers who prepare at home but deliver the presentation at hotels and convention centers, and
(5) Plumbers and other tradespeople who perform their duties at job sites away from the shop.

Many taxpayers who have a second business conducted out of their home will be able to deduct their traveling to and from their “home office” to their main office (previously considered nondeductible commuting mileage) under this expanded definition.

Square Footage Safe Harbor - R.P. 2013-13
Effective for tax years beginning on or after January 1, 2013, R. P. 2013-13 provides an optional safe harbor method for individuals to determine the amount of their deductible home office expenses (see also IR-2013-5). Under this safe harbor, the maximum deduction is $1,500 (which is not indexed for inflation) and the allowable square footage is 300 square feet.
Retirement Plans
Business owners may make annual deductible contributions of up to 20% of business income or $57,000 (in 2020), whichever is less, to a defined-contribution Keogh and may stash away even more in a defined-benefit Keogh.
Note: Employees must be included in your plan on a nondiscriminatory basis. However, employees under 21, those who have worked for you less than a year and part-time employees with fewer than 1,000 work hours in a 12- month period may be excluded.
Hiring Your Children
Having your child work for the family-owned business can be a tax benefit. Earned income is taxed at the child’s tax rate. In addition, the company gets a deduction for the child’s salary. However, children must perform actual services for reasonable compensation.
Children can earn up to $12,400 a year (in 2020) tax-free (the tax-free limit on investment income is $1,100 in 2020). If they open an IRA, up to $6,000 (in 2020) more is tax-free. In addition, you may still be able to claim them as a qualifying child. If your business is unincorporated, you don’t pay Social Security tax on wages paid to a child who is under 19.
Hiring Your Spouse
When a spouse is an employee, they may participate in any retirement plans that you have for employees (pension, §401(k), etc.). In some cases, they may qualify for deductible IRA contributions.
Travel Expenses
Travel deductions are easier for business owners. IRS auditors often ask employees why their company didn’t reimburse them if their travel costs were truly “ordinary and necessary.”
Casualty Losses
Business casualty losses can be deducted in full against business income. Formerly, personal casualty losses were deductible only for itemizers and were reduced by 10% of AGI plus a $100 deductible (§165). However, from 2018 through 2025, the deduction for personal casualty losses is suspended.
Bad Debts
Business bad debts are fully deductible in the year they become uncollectible because they are incurred in connection with a trade or business (§166(a)). However, personal bad debts are treated like capital losses - you may deduct only up to $3,000 a year.
Self-Employment Tax
If a taxpayer is a sole proprietor, the taxpayer will have to pay self-employment tax (§1401). The self-employment tax is the non-employee portion of the Social Security tax-raising system. The self-employment tax rate is normally equal to 15.3% of income (12.4% for social security [OASDI] and 2.9% for Medicare [HI]) from self-employment.

Note: For 2011 and 2012, TRUIRJCA temporarily reduced the OASDI tax rate (but not the HI tax rate) under the SECA tax by two percentage points which resulted in a combined rate of 13.3% (10.4% for OASDI and 2.9% for HI).

Note: Deductible items like home mortgage interest, real estate taxes, state income tax, Keogh plan or IRA deductions, etc. do not reduce self employment tax. However, since 1990, business deductions, plus an amount equal to the self-employment tax on half of self-employment income, are allowable in reducing the self-employment income figure.

In 2020, the social security tax is imposed on the first $137,700 (up from $132,900 in 2019) of self-employment income and the Medicare tax is imposed on all self-employment income.
Incorporation
Before 1990, taxpayers could usually save money on this tax by incorporating. As a corporation, any salary paid (up to $48,000 in 1989) was subject to both individual and corporate FICA tax of 7.51%, or a total tax rate of 15.02%, versus a 13.02% rate for self-employment tax. However, the employer half of the FICA tax was all deductible for corporate income tax purposes, which
could considerably reduce the net after-tax cost of the FICA.
This difference disappeared in 1990, with both the self-employment tax and the combined FICA tax rates both increased to 15.3%. In addition, one-half of the self-employment tax has become deductible, both for income and self employment tax purposes, thus putting self-employed persons on the same footing as incorporated ones for Social Security (FICA and self-employment)
tax purposes.

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