Supporting Family Members Tax-Efficiently: Strategies for High-Income Earners

We kindly ask you to please complete this brief survey after you read the article to provide any feedback you may have or to suggest any future topics that you would like to see us write about. Completion of this survey will enter you into a giveaway of Financial Consulate merchandise..

Individuals who may be supporting family members, such as children or parents, should consider whether shifting income to the family member would help to lower the overall tax liability by taking advantage of lower tax brackets and/or tax credits. There are several tax-efficient strategies to shift income to family members in lower-income brackets, leveraging mechanisms such as capital gains, investment income, or salary distributions for business owners.

Shifting Capital Gains

One of the most effective ways to reduce your overall tax liability is by transferring assets that generate capital gains to family members in lower tax brackets. This strategy is particularly beneficial when a high-income earner can shift highly appreciated assets, such as stocks, bonds, or real estate, to a family member with little to no taxable income.

The capital gains tax rate increases with income, but the rate may be significantly lower or even zero for those in lower tax brackets. Taxpayers in the 10%- or 12%-income tax brackets may qualify for a 0% capital gains tax rate. By gifting or transferring assets to a family member to sell rather than the selling the assets and giving the proceeds to the support family member, you can take advantage of this preferential tax treatment.

Paying a Salary to Family Members (Business Owners)

If you own a business, paying a salary to a family member can be an effective way to shift income while also benefiting from business deductions. If the family member is performing legitimate work for the business, compensating them fairly for their services can reduce the overall taxable income of the business and distribute earnings to a lower-income family member.

As a business owner, you can employ family members and pay them a salary. The key here is ensuring that the salary is reasonable for the work performed. This strategy allows you to deduct the salary as a business expense, reducing the business’s taxable income, while the family member pays taxes on the income at their lower tax rate.

Transferring Investment Assets to Family Members

If you’re a high-income earner, you might also consider gifting investment assets to family members in lower tax brackets. These transfers can occur via outright gifts or through separate tax entities, depending on your goals and the relevant tax laws.

An outright gift of investment assets to a family member, such as a child, could allow them to take ownership of assets, generating passive income or capital gains. This would shift the tax responsibility from you to the family member and reduce the amount of tax you owe. Speak to your advisor regarding gift tax thresholds and any associated reporting requirements to ensure you comply with the law.

If outright gifts are not ideal or you want to keep control over the assets, establishing a family trust or limited partnership may be an option. A family trust can be used to allocate income and gains to beneficiaries (e.g., children or parents) who are in lower tax brackets. Trusts can be complex, and if not structured correctly, could increase the overall tax rather than decrease it. Therefore, it is essential to work with a comprehensive advisor to discuss the strategy before bringing in an attorney to create the trust.

In a Family Limited Partnership, the lower income family members can be gifted ownership interest (gift tax reporting requirements may apply), and then the partnership income is distributed to the family members based on the ownership percentages. Gifting ownership percentages shifts income, but the control of the business is still in the supporting family member.

Taking Advantage of Tax Credits and Deductions for Low-Income Family Members

Another consideration when supporting low-income family members is ensuring they take full advantage of any available tax credits or deductions. These benefits may include income-based tax credits, and by structuring your support in a way that leverages these credits, you can maximize the financial benefit for your family member while minimizing the overall tax burden.

For example, if the supported family member is in college, they may qualify for tax credits that higher-income individuals may not qualify for, such as the American Opportunity Credit or the Lifetime Learning Credit. By transferring highly appreciated securities to the family member to sell, they could generate enough taxable income to utilize the credits, reducing the family’s overall tax liability. Be sure to work with a knowledgeable tax professional familiar with your family’s tax situation before implementing any of these strategies.

Tax Considerations and Limitations

While shifting income to family members in lower tax brackets can be an effective tax strategy, it’s recommended you consult a comprehensive advisor or a tax advisor that understands the reporting requirements or any tax ramifications that would result from implementing the strategy (or strategies).

• Family Member’s Income: It’s important to assess your family member’s total income when considering these strategies. If they receive government benefits, such as social security or welfare, there may be additional tax implications or reductions in benefits when receiving large amounts of income.
• Kiddie Tax Rules: Kiddie Tax applies to dependents that have unearned income that exceeds the annual income limit. If planned correctly, this can be used to generate enough tax to maximize credits; however, it can negate the effect of shifting income if it is not taken into consideration.

Conclusion

Supporting family members in lower tax brackets offers an opportunity for high-income earners to reduce their tax burden. By strategically shifting capital gains, investment income, or even paying a salary to family members through a business, you can take advantage of tax-saving opportunities while ensuring your loved ones benefit financially. Keep in mind that these strategies require careful planning and adherence to tax laws, so it’s essential to work with a comprehensive advisor with tax knowledge to walk you through the details and assist with implementing the most effective approach for your specific situation.

Financial Consulate aims to help lessen the worry and burden of wealth management and enhance financial wellness so our clients can pursue relationships and true fulfillment. Choose the professionals at Financial Consulate as your Certified Financial Planners™ (CFP®) to take advantage of our educational, ethical approach to financial planning. Our services are comprehensive, including tax planning, investment planning, retirement planning, estate planning, and more. We operate completely independently and offer fee-only services to keep your vision in line with our recommendations at all times. While we have offices in Hunt Valley, Maryland, Fernandina Beach, Florida, and Gettysburg, Pennsylvania, we serve clients across the nation. To begin your partnership with a trustworthy wealth advisor, please contact Financial Consulate today.