HIRING YOUR CHILDREN IN YOUR BUSINESS – IT’S NOT SO TAXINGBondBeebe
Brian Wynne, CPA
If you own a business, employing your child can be a great opportunity to teach valuable lessons about earning, saving and hard work. It is also an excellent tax-savings strategy for you and your child. However, before you bring your college kid on your payroll for the summer, there are a number of regulations and savings strategies to keep in mind.
Hiring Your Child as an Employee
Before we look at the tax savings, it’s important to cover two important items that will affect your child’s employment in your company:
Keep it Legal. You must comply with all state, local & federal labor laws, just as if you hired a stranger instead of a family member. These laws are outside the scope of this article, but please be sure that your child is eligible to work in your business. Further, all necessary employment forms must be completed, including an I-9 form proving employment eligibility and a W-4 form which covers withholding.
The IRS Pays Attention to Salary. Once you’ve determined eligibility for work, the next step is to decide what you are going to pay your child. The IRS is aware of the tax savings that are available when employing a child, so the amount of compensation is often scrutinized, and must be reasonable for the work your child is performing.
A good rule of thumb is to pay your child no more or less than you would pay a stranger performing the same tasks. You should document what services your child is performing and pay your child regularly as you would with any other employee, using your payroll system if you have one.
The Tax Savings of Employing Your Kids
When you hire one of your children, the tax savings can be significant. The first benefit is shifting income from your tax bracket to your child’s. If your child is your dependent, he/she cannot claim his/her own federal exemption ($3,950 in 2014). However, a dependent child is eligible for a standard deduction up to $6,200 in 2014.
The standard deduction for a dependent is the greater of $1,000 or their earned income plus $350, up to the maximum of $6,200. Essentially, the first $6,200 of wages paid to a dependent is shielded from all federal income tax, and you can deduct those wages from your business income.
Beyond that, your child’s income would be taxed according to regular tax rates, starting at the 10% tax bracket and going up from there – still likely less than your own tax rate.
There is a concept known as the “kiddie tax,” which forces a child’s unearned (i.e. investment) income to be taxed at the parent’s rate over a certain amount. The good news is the kiddie tax doesn’t apply to earned income. In some cases, wages paid to your child can even help exempt him/her from kiddie tax – children 18 (or 19-23 and a full-time student) are not subject to the kiddie tax if they have earned income that is more than half of their total support.
Double the Benefits: Tax Savings and Retirement Planning
To further minimize your tax obligation, you can also employ a strategy for earnings beyond the first $6,200 of wages. Your child is eligible to make a deductible IRA contribution. The 2014 IRA limit is $5,500 (you must have earned income at least as much as your IRA contribution). This benefit begins to decrease as the adjusted gross income approaches $60,000, but at lower income levels this can be a great benefit. You can essentially shield the first $11,700 of wages ($6,200 + $5,500) from any federal income tax, plus fully fund a $5,500 IRA contribution at a young age, which will grow tax-deferred for a very long time.
Alternatively, you may prefer to use the earned income to fund a Roth IRA contribution. This doesn’t have the same immediate tax benefit on wages over $6,200 (the contribution is not currently deductible), but if the total wages are less than $6,200, there will be no tax anyway, so a Roth IRA contribution has no current “cost” and will grow completely tax-free for your child’s life. The Roth limit is the same as the regular IRA limit ($5,500). Many taxpayers choose to fund the Roth even at higher wage levels because the tax deduction at a child’s low income tax bracket is not as valuable as the potential for tax-free growth.
Finally, if your business has a qualified retirement plan, like a SEP IRA, you can make contributions to your child based on his/her earnings as you would with any other employee, subject to all of the usual limits and eligibility requirements.
You will almost certainly need to withhold income taxes from your child’s wages, but those will be refunded when your child files his or her tax return at the end of the year. If your business is a sole proprietorship or a partnership in which each partner is a parent of the child, a child under 18 is exempt from having Social Security and Medicare taxes withheld. Further, no FUTA (federal unemployment) tax is required to be withheld if the child is under 21. If your business is incorporated, these exemptions do not apply.
Again, the tax savings are significant, but there are a few items to keep in mind in order to stay compliant with IRS regulations. Please consult your tax advisor to find the best mix of reasonable compensation and tax savings that works for your situation.