It can be difficult in the current job market for young people and recent college graduates to find full time and summer jobs. Business owners with children in this situation may be able to provide them with valuable experience and income while generating tax and financial savings for themselves. As a business owner, 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, employing a child age 18 (or if a full-time student, age 19 to 23) may be a way to save taxes on the child’s unearned income. Here are the key considerations.
Convert High-Taxed Income into Tax-Free or Low-Taxed Income
You can turn some of your high-taxed 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.
Example: A business owner operating as a sole proprietor is in the 39.6% 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 $6,100 during the year and doesn’t have any other earnings. The business owner saves $2,415.60 (39.6% of $6,100) in income taxes at no tax cost to his daughter, who can use her $6,300 standard deduction (for 2015) to completely shelter her earnings. The business owner could save an additional $2,178 in taxes if he could keep his daughter on the payroll longer and pay her an additional $5,500. She could shelter the additional income 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 for a child who is subject to the Kiddie Tax, which causes the child’s investment income in excess of $2,100 for 2015 to be taxed at the parent’s marginal rate. The Kiddie Tax has no impact on the child’s wages and other earned income. It only affects unearned income.
The Kiddie Tax doesn’t apply 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 exceeds one-half of his or her support. Therefore, employing a child age 18 or a full-time student age 19 to 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, and earnings exceeding allowable deductions will be taxed at the child’s low rates.
What about income tax withholding?
Your business will probably 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 the preceding year and expects to have none for this year. However, exemption from withholding can’t be claimed if:
- The employee’s income for 2015 exceeds $1,050 and includes more than $350 of unearned income (such as dividends), and
- 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.
You Can Also Save Social Security Tax
If your business isn’t incorporated, you can also save some self-employment (Social Security) tax dollars by shifting some of your earnings to a child. That’s because services performed by a child under the age of 18 while employed by a parent isn’t considered employment for FICA tax purposes.
Example: A sole proprietor who usually takes $120,000 of earnings from the business pays $5,700 to her 17-year-old child. The business owner’s self-employment income would be reduced by $5,700, saving $165.30 (the 2.9% Medicare health insurance portion of self employment tax the owner would have paid on the $5,700 shifted to the daughter). This doesn’t take into account the 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 the federal unemployment tax (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 or her parents.
Note that there is no FICA or FUTA exemption for employing a child if your business is incorporated or is a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work that you’d pay someone else to do anyway.
Your business also may be able to provide your child with retirement benefits, depending on the type of plan it has and how it defines qualifying employees.
For example, if your business has a simplified employee pension (SEP), a contribution can be made for the child up to 25% of his or her earnings, but the contribution cannot exceed $53,000 for 2015. The child’s participation in the SEP won’t prevent the child from making tax-deductible IRA contributions as long as modified adjusted gross income (computed in a special way) is below the level at which deductions for IRA contributions begin to be disallowed. For 2015, that amount is $61,000 for a single individual.
If you have any questions about how these rules apply in your particular situation, contact us. Also keep in mind that some of the rules (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.