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.

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