HIRING YOUR CHILD

Summer is here and it is time to consider saving taxes by hiring the kids. If you own a business you can save family income and payroll taxes by putting junior family members on the payroll. You may be able to turn high-taxed income into tax-free or low-taxed income, achieve social security tax savings (depending on how your business is organized) and even make retirement plan contributions for your child. In addition, employment of a child age 18 (or if a full-time student, age 19–23) may be a way to save taxes on the child’s unearned income..

Here are the key considerations.

Turning your income into tax-free or low-taxed income. You can turn some of your income into tax-free or low-taxed income by shifting some of your business earnings to a child as wages for services performed by him or her. In order for your business to deduct the wages as a business expense, the work done by the child must be legitimate and the child’s salary must be reasonable.

For example, suppose a business owner operating as a sole proprietor is in the 35% tax bracket. He hires his 17-year-old daughter to help with office work full-time during the summer and part-time into the fall. She earns $5,700 during the year (and doesn't have earnings from other sources).

The business owner saves $1,995.00 (35% of $5,700) in income taxes at no tax cost to his daughter, who can use her $5,700 standard deduction for 2009 or 2010 to completely shelter her earnings. The business owner could save an additional $1,750 in taxes if he could keep his daughter on the payroll for a longer period and pay her an additional $5,000. She could shelter the additional amount from tax by making a tax-deductible contribution to her own IRA.

Family taxes are cut even if the child’s earnings exceed his or her standard deduction and IRA deduction. That's because the unsheltered earnings will be taxed to the child beginning at a rate of 10%, instead of being taxed at the parent's higher rate.

Keep in mind that bracket-shifting works even if the child is subject to the kiddie tax. The kiddie tax only causes a child’s investment income in excess of $1,900 for 2010 to be taxed at the parent's marginal rate. It has no impact on the child’s wages and other earned income, which can be sheltered by the child’s standard deduction.

The kiddie tax applies to a child who is age 18 or a full-time student age 19 through 23, if the child’s earned income for the year doesn't exceed one-half of his or her support. Thus, employing a child age 18 or a full-time student age 19–23 could also help to avoid the kiddie tax on his or her unearned income.

For children under age 18, there is no earned income escape hatch from the kiddie tax. But in all cases, earned income can be sheltered by the child’s standard and other deductions, as noted above, and earnings in excess of allowable deductions will be taxed at the child’s low brackets.

What about income tax withholding? Your business probably will have to withhold federal income taxes on your child’s wages. Usually, an employee can claim exempt status if he or she had no federal income tax liability for last year, and expects to have none for this year. However, exemption from withholding can't be claimed if (1) the employee's income exceeds $950 for 2009 or 2010, and includes more than $300 of unearned income (such as dividends), and (2) the employee can be claimed as a dependent on someone else's return. Keep in mind that your child probably will get a refund for part or all of the withheld tax when he or she files a return for the year.

Social security tax savings, too. If your business is not incorporated, you can also save some self-employment (i.e., social security) tax dollars by shifting some of your earnings to a child. That's because employment for FICA tax purposes doesn't include services performed by a child under the age of 18 while employed by a parent. For example, let's say a sole proprietor who usually takes $120,000 of earnings from the business pays $5,700 to her 17-year-old child in 2009 or 2010. The sole proprietor's self-employment income would be reduced by $5,700, saving her $165.30 (the 2.9% HI portion of the self-employment tax she would have paid on the $5,700 shifted to her daughter). This doesn't take into account a sole proprietor's income tax deduction for one-half of his or her own social security taxes.

A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents.

Note that there is no FICA or FUTA exemption for employing a child if your business is incorporated or a partnership that includes non-parent partners. However, there's no extra cost to your business if you're paying a child for work you'd pay someone else to do, anyway.

Keep in mind that some of the rules about employing children (such as the maximum amount they can earn tax-free) change from year to year, and may require your income shifting strategy to change, too.

HIRING YOUR CHILD

Larry, A while back you wrote an article in your newsletter about paying the kids during the summer. I have a teenager that is working for me and I can’t find the article. Could you send me a copy?

Brian

Brian, thanks for the question. I am sure that there are others that would be interested in this great tax planning technique. Things have changed a little since I posted the article so I will update.

If you are self-employed, employing your children (or grandchildren) can lower your family’s overall tax bill. By paying your child wages, you effectively shift income from a higher bracket taxpayer (you) to a lower bracket one (your child). Because the income is considered "earned income" to your child (as opposed to "unearned income" like dividends and interest), it can be offset by his or her standard deduction ($5,700 for 2009). To the extent the income is taxed, a low 10% rate will generally apply to all or part of it. Thus, the family’s income tax savings can be significant since some of the income normally taxed at your rate might escape taxes entirely or be taxed at your child’s low rate.

There can also be payroll tax savings when employing your child. Wages paid to a child under the age of 18 from a parent’s sole proprietorship are exempt from social security and unemployment taxes. Thus, depending on your total self-employment earnings, your tax savings can also include up to an additional 15.3% of the amount of wages you pay to your child, since you avoid paying self-employment tax on that amount and no payroll taxes are due on the wages.

Here is an example. Suppose a business person operating as a sole proprietor is in the 35% tax bracket. He hires his 17-year-old daughter to help full-time during the summer and part-time into the fall. She earns $5,350 during the year (and doesn't have earnings from other sources).The business person saves $1,872.50 (35% of $5,350) in income taxes at no tax cost to his daughter, who can use her $5,700 standard deduction for 2009 to completely shelter her earnings. The business person could save an additional $1,400 in taxes if he could keep his daughter on the payroll for a longer period and pay her an additional $5,000. She could shelter the additional amount from tax by making a tax-deductible contribution to her own IRA.

Employing your teenager has the side benefit of enabling him or her to make an IRA contribution. With earned income (received from your business or elsewhere), your child is eligible to make a 2009 contribution to a traditional or Roth IRA, up to the lesser of $5,000 or earned income. Generally, the Roth IRA is the better choice because although no deduction is allowed for the contribution, the earnings will never be taxed if your child does not withdraw them until at least age 59½. That’s a long time for the funds to grow. And if you choose, you can gift your child the funds to make the allowable contribution.

Before leaving this subject, it’s important to point out two things. First, you must make sure that any wages you pay your child are reasonable based on the work performed and the child’s age. Second, if your child is in college or is going to college soon, shifting income to him or her can have a detrimental impact on your family’s eligibility for need-based financial aid.

Please let me know if you need further information. It is a pleasure serving you.

Larry Kopsa CPA

HIRING YOUR CHILD

Larry, I know you have answered this question before, but I can't seem to find it on your blog anywhere. How much can I pay my 2 kids a year for odd jobs around the shop and not have to pay taxes on them? They do odd jobs such as folding towels, dusting and cleaning. Also, how do I go about doing the tax forms on them, do I just leave the Social Security and Medicare spots blank on the W2's? Thank you for any info you can give me.

Shannon

Shannon, money that you give to your children, grandchildren, or even parents is a deductible business expense if you pay them to perform bona fide work for your business, and pay them reasonable compensation for that work.

Would I rather give my 12 year old son Ryan an allowance or a wage?

Let’s do the math. If I am in a 33% bracket I need to make $30, give the government $10 which leaves me $20 to give to my son. On the other hand, if I give him a wage of $20, I have a $6.60 tax deduction so effectively I only am paying him $13.40 after taxes. It is a no brainer.

At that point, it isn’t allowance. It’s wages. If you’re hiring your kids, they might even learn not to treat you like “The First National Bank of Mom and Dad”:

• Your child can earn up to the standard deduction for single taxpayers ($5,700 for 2009) before they owe tax on their income. The next $8,350 is taxed at just 10%. Earned income isn't subject to the “kiddie tax” for children under 19 (or dependent full-time students under age 24). Other family employees pay tax at their regular rate.
• The Tax Court approves wages for children as young as 7.
• Your family employee’s work should be directly related to your business.
• Pay your employee (child) a reasonable wage for their age and the service they perform. Their wages should be similar to amounts paid for similar services by similar businesses under similar circumstances—with adjustments made for their age and experience.
• To verify your deduction and audit-proof your return, keep a time sheet showing the dates, hours, and services performed. The more you pay, the better time records you should have.
• Pay your child by check, and deposit the check in an account in the child's name. This can be a Roth IRA, Section 529 college savings plan, or custodial account.
• You can’t use custodial assets for your obligations of parental support; however, parental support doesn’t include “extras” like providing a bike, saving for a car, prom dresses, summer camps, and similar expenses.
• If your business is taxed as a proprietorship or partnership, you don’t owe Social Security or Medicare taxes on your child’s wages until they reach age 18. You don’t owe unemployment tax until they reach age 21.
• Hiring family members to help work in your business also lets you establish employee benefit programs such as a medical expense reimbursement plan, education assistance plan, and retirement plans.
• The IRS always scrutinizes year-end transactions so I always recommend paying the child monthly to avoid IRS questions.

In summary, by paying your children for working you are able to effectively deduct expenses that might be considered personal. If you have any further questions let me know.

Larry Kopsa CPA