Q:

Subject: Question about your income shifting technique

Dear Mr. Kerstetter,

Thank you for your informative web site.  I don’t understand the income shifting technique described at taxguru.org/corps/scorp.htm, a portion of which is quoted:

“One of the most useful tools in the tax game arsenal is the ability to shift income between taxable years. … Toward the end of your personal fiscal year (12/31), you bleed off some of your taxable income to your C corp by paying it for something like rent or marketing services.  In January, your corporation can pay it back to you.  Near the end of the corp's fiscal year, bleed its net profits out by paying yourself.”

I assume this income shifting technique requires me to own two businesses: a sole proprietorship and a C corp.; otherwise, the IRS would disallow my 1040 schedule A itemized deduction for rent or marketing payments to the C corp. as personal expenses and not business expenses. 

I further assume that my sole proprietorship needs a source of (at least occasional) income separate from my salary, bonus, or dividends as an employee/stockholder in the C corp.; otherwise, the IRS would argue that my sole proprietorship is really a hobby.  For example, if all my 1040 income originates from my C corp. and every year I file a 1040 schedule C with deductions for rent or marketing payments to the C corp., eventually the IRS is going to audit and penalize me.

I already own a C corp., so I know how it generates revenue.  But, what business is my hypothetical sole proprietorship supposed to be in and where does it get its separate income that doesn’t originate from the C corp.?  Should I have some of my customers pay my C corp. and others pay my sole proprietorship?  Wouldn’t the IRS view that as a scam?

I also fear that the money my hypothetical sole proprietorship would be paying the C corp. would be so large that the IRS would view the deduction for rent or marketing services as unreasonable. 

How do I implement this income shifting technique without getting audited and penalized?

Regards,

A:

There are various ways in which income can be shifted back and forth between your 1040 and an 1120. You will need to work with a professional tax advisor who understands how to properly use C corps in order to set up the best strategy for your particular situation.

A lot does depend on where the original income is from.  If it's as W-2 wages, your options are more limited than if they are as a 1099 independent contractor.  Generally, if all income is from W-2, the income would need to be shifted via Misc. Schedule A deductions.  This is why it's a good idea to work with your employer to convert all or part of your compensation to 1099.  That would allow you to easily use Schedules C and E, which have much greater tax saving opportunity than does A.

Good luck.

Kerry Kerstetter

 

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 6/30/2005 10:22:00 PM Send this post: