Ep. 8 | Red Diagnosis (high marginal tax rate)
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Speaker 2:Welcome everybody back to Teaching Tax Flow, the podcast, episode eight. Year end, we're looking at going into '23, believe it or not. As we close out '22, let's talk about a really, really important topic, important to us at at Teaching Tax Flow. So I'm John Schopolsky, one of the cohosts here at Teaching Tax Flow, the podcast. My counterpart, better looking, smarter, elder, Chris Pacquero.
Speaker 2:It's
Speaker 3:well elder. Much elder. It's not
Speaker 2:that bad. It's not that bad. But now that you're on the spot, Chris, what's your favorite year end red diagnosis tax strategy prescription?
Speaker 3:Well, John, thanks for that introduction. Again, we really appreciate everyone's time and open mindedness. We're gonna be going through a series, this month where we're looking at different tax planning, rather our color code four color coded diagnosis, and we're picking on our favorite year end tax planning strategy or prescription for each of the four diagnoses. Today, we're talking about the red diagnosis into the teaching tax flow ecosystem. We all know that the red diagnosis is when a taxpayer has a high marginal tax rate or higher than expected future marginal tax rate and that taxpayer can benefit from an immediate one time tax deduction.
Speaker 3:It's ideal for marginal tax rate taxpayers in the 25 or higher tax bracket. So marginal tax rate. I'm sorry.
Speaker 2:And so, really, that immediate that onetime deduction obviously fits perfect at the end of the year. Right? Because the clock is ticking. You got you got the New Year rolling in soon. Mhmm.
Speaker 2:What's your favorite? What and even if you have to talk about a couple maybe. Totally totally fine. But maybe maybe tell us what those are and then, you know, maybe a little bit of an example of each one of those as well.
Speaker 3:Happy to do that. I'm going to first preface this by saying what we're gonna talk about today, the strategy that I'd like to discuss for a red diagnosis year end, doesn't necessarily mean that's my favorite red diagnosis strategy. Spoiler alert, we're gonna have some favorites that we're picking in future episodes. Why do I say that? You as a listener and a part of the teaching tax flow ecosystem, you've learned that some that each tax planning, prescription has different attributes.
Speaker 3:One of the attributes that we teach is the attribute of a p, p as in Paul. P means that you could typically implement that strategy post year end. For example, John, a SEP IRA contribution for a for a self employed business owner, that contribution does not have to be made before the end of the year. You can make that up until you file your 2022 tax return into 2023 and still count it for '22. Because it's a p at p type of, implementation, I can't count it as a year on strategy.
Speaker 2:Makes sense. Makes sense. And, so really and and just to step back even a little bit further, I know we'd mentioned, you know, some different ones. So part of the diagnosis color coding, obviously, we have red, green, purple, and gold. So red is the highest, if if I'm not mistaken correct, the highest MTR, so your highest your marginal tax rate of 25% or above.
Speaker 2:Right?
Speaker 3:Correct. So my favorite red diagnosis at year end would be I'm gonna cheat on. I'm not gonna pick one. I'm gonna pick I had assumed
Speaker 2:this was gonna be complicated,
Speaker 3:but it's a good one. Okay? The two are income shifting. So income shifting is my favorite year end tax prescription for a red diagnosis. And that income shifting is gonna come in two different forms.
Speaker 3:One income shifting to family members and then income shifting to related business entities. Both of these prescriptions have the same attributes in the teaching tax law system. One of the attributes is a plus. What a plus means is that the tax benefit is much greater than the tax flow or the cost of the prescription. I'll give you an example of something that is opposite of that.
Speaker 3:That SARP IRA contribution, if you're in the 30 marginal tax rate, a thousand dollar subcontribution would reduce your taxes by $300 So that's a nice benefit, but tax tax flow wise, you're still minus $700 Makes sense. So it's very rare we find a prescription that is a plus. So When you are talking about income shifting to a related business entity, income shifting to family members, those are pluses, very rare. They also in our system are an A. An A is an advanced tax strategy.
Speaker 3:We have basic, advanced and ultra advanced. So an advanced tax strategy is typically gonna be something that you work with your tax preparer or tax professional with to implement. It's not a basic tax strategy that you would implement on your own.
Speaker 2:So, really, with the other example, I I know you'd mentioned, you know, income shifting to family members. Would that would that actually qualify or would this qualify as that being a, we'll say, a dependent in a in a household. Say I'm a business owner, and my son or daughter helps me file or not file, you know, licking envelopes at the end of the year to mail Christmas cards to my clients. You know? Got you got tons of
Speaker 3:cards for cut off the gosh. I see. Well, alright.
Speaker 2:It's the sticky ones. You pull the little stick back. You know, you just it it works. But would that actually be a good example of that, or is that something completely different?
Speaker 3:That's a good example, if you you mailed Christmas cards. Mhmm. I don't know if you do. I don't think I have well, we're guys, so
Speaker 2:My my wife does a great job.
Speaker 3:Yeah. I'm sure. Yeah. Exactly.
Speaker 2:So it has to be legitimate business.
Speaker 3:Exactly. So income shifting of family members. In general, in general, it's going to be a dependent child. It doesn't have to be. It could be a dependent, parent.
Speaker 3:It could be a non dependent family member. But the idea is, I'm gonna preface this by saying, whoever is being paid is being paid for legitimate work at a legitimate rate. So let's assume that those two qualifications are met. Now what is legitimate?
Speaker 2:Not washing your dog for a hundred and $75 an hour. No. Is not
Speaker 3:that is not legitimate. Idea. You need to be you need to be reasonable. So in the situation where income shift from your family members, a lot of times it can be a dependent child. That child why does this strategy work?
Speaker 3:Well, that child is in probably any potentially 0% marginal tax rate. That child would be a green diagnosis in our book, but we're going to save that for another episode. Parent is in the red diagnosis marginal tax rate of over 25%. So in general, if someone is paid $10,000 that person is in a 25% marginal tax rate, that would be a tax savings of $2,500 If the recipient of that compensation is in the 0% marginal tax rate, they pay $0 of federal income tax. Now I'm going to that's just federal income tax.
Speaker 3:There are several considerations that have to be thought of when it comes to payroll taxes, and there are special rules for paying minors from someone that's self employed or single member LLC.
Speaker 2:So right now, you're sending Venmo to my son for $2,500.
Speaker 3:No. No. This child has to be something legitimate. Now a lot of business owners do have their their children working in their business, helping them maybe with their website, maybe helping them model or maybe help them, create a following. They can help them in a variety of ways.
Speaker 3:It could be manual labor. It could be we pay our children for cleaning our pool here and at our short term rental property in Florida. Not an exorbitant amount of money, but enough to enough for them to make it worth it to go out there and and take care of the pool when we're here. So those are things that have to be considered. And we always talk about tax flow versus cash flow.
Speaker 3:And typically, especially if you're paying someone that's a dependent, that income estate is kept within the household. So that tax arbitrage is is important.
Speaker 2:Right. So obviously, there's a lot of benefits to to either of those. Right? So really, as a whole, a good AKA your favorites, for year end is income shifting. So anything else on those specifics?
Speaker 2:Obviously, business entities is one and family members is another one. So different different tasks, you should say, but semi related. Yeah.
Speaker 3:I'll put a bow on family members. One thing to consider would be, yes, make sure that family member is being compensated fairly. Make sure they're doing legitimate work for your business. Make sure that, there is enough tax benefit to make sense, and consider blending strategy. So what a lot of, people in the teaching tax law ecosystem do is if they are paying, a dependent, for legitimate work and that dependent is in the 0% marginal tax rate, we're not talking about payroll taxes right now, so they're paying no federal income tax, that dependent then could contribute to a Roth IRA, which is our gold strategy, and that income could grow tax free for the rest of their life.
Speaker 3:So blending those strategies together, especially when you have someone that's potentially in a very high marginal tax rate, high taxable income and ineligible to make Roth contributions. So think about blending when it comes to that income shifting to family members. And then there's that second type of income shifting that we teach, income shifting to related business entities. Mhmm.
Speaker 2:And, actually, so so even backtracking just a little bit more, just to make sure we're a % clear on this. So the income shifting to family members specifically. So let's let's use an example. Right? Let's say someone is a solopreneur.
Speaker 2:You know, they they work at home or out of an office. It's really just them in the office. They say they don't have payroll set up, and they're dependent, legitimately helps them with work that, you know, at at a very reasonable hourly rate. Do they need to set up a formal payroll system to do that, or can it just be we wouldn't call it a slide of the slide of cash or, hey. Here's a check.
Speaker 2:You know, you you worked a hundred hours at we'll just say, $10 and 10 dollars an hour. Say, oh, here's here's a thousand bucks. It's deposited into your account for you. How how do you legally have to go around this or ethically?
Speaker 3:Well, we do talk about legally and ethically reduced the tax you pay in your lifetime. We are not attorneys here, Sean, as you know. That being said, in this fact pattern, I would I would take the stance that the child is a an employee of the parent, not an independent contractor. Employees are paid on a w two, and you would have payroll. Now that child might be exempt from some of the payroll taxes, and that's what we have to think about.
Speaker 3:To pay a child a thousand dollars is probably not the juice isn't gonna be worth the squeeze because there are costs associated with running payroll. If the child had 10 to $15,000 of legitimate work and you're shifting income 10 you know, let's say $10,000 at a 30% arbitrage, that'd be $3,000 of tax savings. And let's say it costs $500 a year to process the payroll, which is reasonable using we have a we have a partner that we can turn our teaching tax flow people onto to do a do it yourself payroll provider. In that case, it makes sense. Tax flow is better than the cash flow.
Speaker 3:So there is a practical side of things, but there's also reasons you would pay someone in the family, that just to feel like they've earned some some money. I mean, we keep talking about dependence. There's a lot of times that a spouse might pay one of the other spouse even though they file together. If a spouse is helping another spouse doing legitimate work, there's a lot of advantages to potentially paying your spouse. In general, I'd say 75% of the time, it doesn't make much sense, but there's those rare circumstances where it would make sense when you are pairing this red diagnosis with potentially, you're potentially pairing it with gold or green, meaning if let's say that you let's say that you're a household that has a lot of medical expenses.
Speaker 3:This is just one example. Okay? And those medical expenses, because your income is high, are not really deductible on Schedule A. Itemized deductions, and of course we're going to have an episode on itemized versus standard deductions. In that case those deducts, that would be money that's going out the door that you're not getting a deduction for.
Speaker 3:In the case that one spouse is doing legitimate work for another, the person doing the work, you might want to put that spouse on as a W-two employee and implement what's called a Section 125 plan, or I am sorry, 105 plan. There are so many sections by 105 plan and that allows the business to reimburse the employee for any out of pocket medical expenses. So income shifting between spouses to either take non deductible expenses and make them deductible or potentially, reduce Social Security tax exposure makes sense as long as the spouse is doing legitimate work. And that's a fact pattern we we see quite often when one spouse might be handling the business affairs, the office work, and one spouse might be out in the field doing something. You have to be careful with the section one zero five plan because if you have other employees, you have to offer it to to those employees as well.
Speaker 2:Which actually, this segues into into a question I I recall hearing a lot of. So we was it maybe about a month ago or so if that? I know, a a friend friend of yours, Bill Allen, hosted a great event over in over in Orlando not too far from where we are right now, for Flip Hack Live. And I I remember kinda overhearing the question be asked of you and the team every once in a while. I'd probably say half a dozen times in in one or two days is, oh, well, my my son or or my wife or somebody works with me.
Speaker 2:Obviously, they're, you know, in in real estate investing. It's really a team of them and and their family. Is it and and this kinda starts to bridge a little bit into the to the legality side of it. But does this have to be on a recurring payroll? Like, does this have to be oh, well, you're a w two employee.
Speaker 2:You're getting a biweekly or a monthly paycheck, quote, unquote, or can it be a onetime end of year Mhmm. Process? It can I
Speaker 3:mean, it could be either? I would say that whatever's typical for that type of employment. I mean, there are there are some employees that get paid on a per diem basis or per hour basis. So if there's not work going on, then they wouldn't be paid. There are some employees that are paid on a salary basis, either monthly.
Speaker 3:Typically, what we see is in that in a fact pattern where it's an officer or or a salaried spouse, we we would recommend that they're paid on a monthly basis. Gotcha. In in that yes.
Speaker 2:So So if you're if you're sealing up and and licking Christmas card envelopes in in February, you're just late. You're just you're just late. Maybe you're week ahead
Speaker 3:for the next year.
Speaker 2:Oh, yep. You're being proactive.
Speaker 3:We're doing celebrating another holiday. Next week. Before we before we wrap up the show, I wanna touch on income shifting to related business entities. There are several examples of that. We we teach people in the teaching tax flows, ecosystem that not all income is taxed the same.
Speaker 3:Different types of income is taxed at a different marginal tax rates. And the idea of income shifting to related business entities means that taking income that's taxed at a higher marginal tax rate and shifting it to a lower marginal tax rate type of income. Assume though that this is done legitimately in a at a fair market value on a fair market value basis. So the most popular example would be, let's say you have a medical practice and you bought a building and you run that medical practice out of that commercial building. The medical practice should pay you.
Speaker 3:You should probably set up a separate, maybe a single member LLC or just however you want to do it, a separate entity or maybe even own it personally, own that building so you could take advantage of the depreciation deduction, etcetera. And let's say the medical practice is a C corporation or even someone that's self employed. Anyway, the medical practice could pay the landlord, which is yourself as well, fair market value rent and that rent's going to be taxed in general at a much lower marginal tax rate than self employment income or corporate profits. That's just a, you know, again, one example of income shifting to related business entities. We have several that we teach on all the way from real easy to very, very advanced.
Speaker 2:And that's really a great example of, you know, I know we're always harping on, you know, the importance of planning and and building a strategy or a long term strategy and a short term strategy. But that's something that you definitely you don't you don't wanna have to kinda craft that up, at the witching hour. Right? That's something that you definitely you would build into to everything that you have going on. And, obviously, that's something that you guys have done for numerous clients.
Speaker 2:I've heard some great stories and success stories and testimonials from over the years too. So it's not a new concept by any stretch of the imagination.
Speaker 3:Absolutely not. And we are we're excited. They the listeners are opening their mind and thinking about little outside the box on some of these strategies. The higher your marginal tax rate, typically, the higher the tax benefit is from these strategies. So those are my favorite strategies, or prescriptions for the red diagnosis at year end.
Speaker 3:Income shifting to family members, income shifting to related business entities. We appreciate your time, and we're gonna be back next week with another color coded diagnosis to to dive into. Absolutely. Well, thank you everybody again for for chiming in with us here on the Teaching Tax Flow podcast. Just to reiterate it again too, this is just the red diagnosis.
Speaker 3:We're gonna be looking at green, purple, and gold in the upcoming weeks. So be sure to share this with a friend if
Speaker 2:you think it's something that they could benefit from. If they or you or anybody that you know may have any questions on these, please feel free to reach out. If it's something that our team, does not have the, the response, I should say, actually built into our platform, we will absolutely love to connect you with some of our resources. As we continue to build out our platform specifically, we are building and building and building on top of this. So thank you everybody for your time, and we will see you next week.
