Reducing Your Applicable Tax Rate

(5 of 7)

Reducing Your Applicable Tax Rate

Strictly speaking, one cannot actually lower his or her own tax rate. There are a limited number of steps and strategies, however, that have the same result, as a practical matter.

Shift it to a child

You can "shift" family income to a child. If it’s possible and otherwise makes sense, consider hiring your child to work for you or your company. As long as the child is paid a reasonable salary for work actually done, this is perfectly legal. You can deduct the wages, and your child will report the income on his or her own tax return, at a tax rate that is (presumably) lower than yours. This is a good way to help you and your child pay for college, for example.

Another technique is to make your child a part-owner of your business, so that, again, the tax on his or her share of the profits will be taxed at a lower rate than yours. Note that, unlike the wages paid to a child, this kind of income will be "unearned" and subject to the limitations described below.

You can also give some of your investments to your child, so that a portion of the investment income will be tax-free or taxed at his or her lower rate. The first $1,300 of unearned income is generally tax-free; the next $1,300 generally taxed at the child’s tax rate, and anything over $2,600 generally taxed at the higher rates applicable to estates and trusts. These rules for taxing the child’s unearned income are known as kiddie tax rules.

The kiddie tax

The kiddie tax generally kicks in when investment income in your dependent child’s name is greater than $2,600. The kiddie tax will be in effect until your child reaches age 19, or to age 24 if he or she is a dependent full-time student. If your child is older than that, you can still place your investments in his or her name, but in that event, of course, those assets are not legally subject to your control.

The type of organization matters

Choosing the form of organization under which you do business also can help lower the applicable tax rate. The "regular" C corporation, for example, is itself a tax-paying entity, yet distributions from it (whether as salary or dividends) are taxed again to whoever receives them. On the other hand, if you conduct business as a sole proprietorship or a "pass-through" entity (e.g., a partnership, limited liability company or S corporation), there is no tax at the entity level. Instead, income is taxed only once.

As part of the 2018 Tax Cuts and Jobs Act, taxpayers with pass-through businesses will be able to deduct 20% of their pass-through income. For example, if your business earns $100,000 in profit, you will be able to deduct $20,000 of it before normal tax rates kick in. The law uses phaseout income limits that apply to various "professional services" business owners. Given how new the law is, it may be wise for business owners to consult a tax professional for guidance.