The tax burden of business owners are significantly different (and usually much more) than employees. For example, business owners must match social security and Medicare contributions paid by employees. Depending on the number of employees in a business and the amount of the payroll, the matching obligation can “cost” the business a substantial amount. Consequently business owners are constantly looking for ways to decrease their tax burdens. An often overlooked opportunity available to business owners that can result in significant tax savings involves hiring children (or other family members).
Of course, in order to take advantage of these opportunities it is very important to follow IRS guidelines and to consult with your tax advisor. No one strategy fits all situations. But there are many opportunities business owners may be able to include as part of a tax-lowering strategy.
For example, did you know that you can save family income and payroll taxes by putting junior family members on the payroll? You may also 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 19-23) may be a way to save taxes on the child’s unearned income, as explained below.
Here are some key things to consider if you are a business owner that may benefit from these IRS rules:
Turning high-taxed income into tax-free or low-taxed income
Shifting income to a child through payment of wages to them is a simple way of converting some of your high-taxed income into tax-free or low-taxed income. 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. Although it is permissible to “make work” it isn’t permissible to pay for services not rendered. Therefore whatever job a child is given to perform they need to actually work.
For example, suppose a business owner operating as a sole proprietor is in the top bracket for federal income tax (39.6%). 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).
By paying his daughter $6,100 rather than himself the business owner saves $2,415.60 (39.6% of $6,100) in income taxes. If the daughter has no other income she will pay no tax on the income she earns (daughter can use her $6,300 standard deduction for 2016 to offset her earnings). Family taxes can also be cut even if the child’s earnings exceed his or her standard deduction 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.
The above strategy 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 2016 to be taxed at the parent’s marginal rate. The kiddie tax has no impact on the child’s wages and other earned 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. 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 rates.
Income Tax Withholding
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. That can be the case for teenage children who have yet to enter the workforce prior to working for your business. However, exemption from withholding can’t be claimed if (1) the employee’s income exceeds $1,050 for 2016, and includes more than $350 of unearned income (such as dividends) for 2016, and (2) the employee can be claimed as a dependent on someone else’s return. But 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.
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 it 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 2016. The child’s participation in the SEP won’t prevent the child from making tax-deductible IRA contributions as long as adjusted gross income (computed in a special way) is below the level at which deductions for IRA contributions begin to be disallowed. For 2016, that figure is $61,000 for a single individual.
There are a lot of financial burdens when you own a business, and certainly paying all the various taxes is one of the biggest. That’s why using these tax-saving tips wherever applicable can not only save you some tax dollars but can help your child at the same time. That is a win-win all business owners should take advantage of.