Monday, September 29, 2014

Hiring Children to Lower your Tax impact

If you are a small business owner, instead of looking out in the labor force for employees, maybe hiring your child is an option for you. Don't overlook these three benefits of hiring your minor child to perform necessary operations of the business.

Standard Deduction

One of the benefits of paying your child W-2 wages is that their wages are subject to a whole new standard deduction. For a dependent filer the (2013) standard deduction is the greater of $1,000 or earned income plus 350 (not greater than $6,100).

That means if you pay your child 6,100 in wages, then the entire amount that would have been included in your taxable income is now shifted to your child dependent resulting in 0 tax.

Lower Tax Bracket

Another benefit of shifting your income to your child dependent, is you are able to move your income from your higher tax bracket to your child's lower tax bracket. Lets say you are in the 25% tax bracket, and your child is in the 10% tax bracket, you benefit by this shift.

No FICA Taxes

Most of us know that we are all subject to paying social security/medicare taxes. There are a few exceptions to this rule. According to the IRC Section 3121(b)(3)(A) a minor employed by their parents are exempt from such tax. Therefore the wages that would have been subject to 15.3% in FICA taxes, is now 0%.


Lets say A & B are married and own a small business that produces $100,000 in income annually. In 2013, the couple employs their 15 year old daughter to help out in their business and pay her W-2 wages of $10,000.

Under this scenario, $6,100 of that amount is taxed at 0%, because of the standard deduction for the dependent child. The remaining amount of $3,900 is taxed at 10% (the daughter's tax bracket).The entire $10,000 is exempt from FICA tax. The total tax paid on the 10K of income is $390.

On A&B's return, they would report $90,000 of self employment income, which would result in $24,975 in tax.

Conversely if the family did not hire their child, the self employment income would be 100,000 and the tax on that income would be 28,711.

The tax savings here is $3,346 [28,711 - (24,975 + 390)]. Effectively, you have gained an employee, spared yourself the heartache of paying the IRS an extra 3K, and kept your 10K within the family. Lets hope you can convince your child to use that money to pay for college!

Documentation, Documentation, Documentation!
One thing I would like to emphasize here is that if you are going to take this approach, you should be able appropriately keep record of this strategy.

First, I recommend you appropriately substantiate the the work your child has done. Make them clock-in, signoff on work, or some sort of record that shows they really did work to earn the wage.

Second, find a way to justify their pay, you wouldn't pay someone $90K to do your small business secretarial work. Look out in the market place and see what other companies are paying to do the work you are hiring your child to do, and base their wage as if it were an arm's length arrangement.

Third, make sure you issue a W-2 to your child for the wages they earned during the year.

Essentially, you want to do everything you can to substantiate that your child did work and you paid them a fair wage for doing that work, and you should be okay should the IRS have any questions.

Sunday, September 21, 2014

Using Your 401k To Get an instant 65% Returns

First off I would like to admit that my post is a little misleading. I would like to clarify that this post is not about investing in penny stocks or other risky investments to make ridiculous returns in your 401k.

However, the money you set aside in your 401k can lower your tax liability and have the same effect as getting an instant return, sometimes returns as high as 65%.

In order to get this type of treatment you must be eligible for the Earned Income Credit, the retirement savings contribution credit, and have a 401k account you can contribute to (in some cases a traditional IRA account may suffice, but not always).

Here is a hypothetical scenario:

A couple Married Filing Jointly with one dependent makes $43,250. Lets say only one spouse goes to work, and is eligible to participate in a 401k plan with their employer.

with $0 contributions to their 401k plan, the tax due by April 15th would have been $2,456 (given the 2013 tax, exemption & standard deduction rates).

With the same situation $2,000 of contributions to their 401k plan, the tax due by April 15th would now be $847. Nothing has changed, except the family has deferred $2,000 of income to save $1,609 in tax ($2,456 tax in the prior example, less the $847). The only issue becomes, can the family afford to lock up the $391 in thier 401k account to take advantage of this gain.

Note that at first glance this example appears to have an 80% return. (1,609/2,000 = 80%). The reduction in tax attributable directly to the 401k account in my opinion is not a real "return" because this money will get taxed later when you withdraw the funds at retirement. The real return comes from the increase in credit you receive with your EIC credit (increased from $0 to $309) and the credits you receive from the Retirement Savings Contribution credit (increased from $0 to $1,000). The total of $1,309 you get by contributing $2,000 to your 401k is a 65% return.

This works because when you contribute money to your 401k account your W-2 Box 1 wages are reduced. This is the amount that gets reported on your tax return. Note had you contributed your money to a traditional IRA, you would not have the benefit of reducing box 1 wages, and instead get a "for AGI deduction"** which has the chance to screw up your EIC calculation (depending on your circumstances).

The reduction in wages lowers your income that is considered for the EIC and Retirement Savings credit, which is more beneficial for lower income earners.

If you can afford to take a hit on cash flow to increase your overall wealth, I think that it would be well worth the investment now before your income rises over the years and you can no longer take advantage of these credits.

**A "for AGI deduction" is a deduction that reduces your Adjusted Gross Income, (line 37 on form 1040) which is commonly used to determine which tax payers are allowed to use certain credits such as the EIC.