Tax Savings From Hiring a Child in
the Family Business
As the owner of a business, you should be aware that you can save family
income and payroll taxes by putting junior family members on the payroll. 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. Starting next year when changes broadening the kiddie tax
first go into effect, in many cases, employing a child who is age 18 or a full time
student age 19 through 23 can save taxes on his or her unearned income, as explained
below. Here are the key considerations.
Turning 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. The work done
by the child must be legitimate, and the amount you pay the child must be reasonable for
your business to deduct the wages as a business expense.
For example, suppose a business person operating as a sole proprietor is in the 35% 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 $5,350 during the year (and doesn't have
earnings from other sources). The business person saves $1,872.50 (35% of $5,350) in
income taxes at no tax cost to his daughter, who can use her $5,350 standard deduction for
2007 to completely shelter her earnings.
The business person could save an additional $1,400 in taxes if he could keep his daughter
on the payroll for a longer period and pay her an additional $4,000. She could shelter the
additional amount from tax by making a tax-deductible contribution to her own IRA.
And 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 if the child is under age 18 and thus
potentially subject to the kiddie tax for 2007. For this year, the kiddie tax only causes
an under age 18 child's investment income in excess of $1,700 (for 2007) to be taxed at
the parent's marginal rate. It has no impact, however, on the child's wages and other
earned income, which can be sheltered by the child's standard deduction. Starting next
year, due to a recent tax law change, the kiddie tax will be expanded to apply where:
- a child is age 18 or a full time student age 19 through 23;
- the child's earned income for the year doesn't exceed one-half of his or her support;
- the child has more than $1,700 of unearned income (but the $1,700 may be higher after an
inflation adjustment is released later this year for 2008);
- the child has at least one living parent at the close of the tax year; and
- the child doesn't file a joint return for the tax year.
Thus, starting next year, employing a child age 18 or a full-time student age 19-23 could
cause his or her earned income to exceed more than half of his or her support. This,in
turn, could help to avoid the kiddie tax on the child's unearned income. Note, however,
that for children under age 18, there is no earned income escape hatch from the kiddie tax
this year or in future years. But remember, 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 brackets.
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. However, exemption from withholding can't be claimed if (1) the
employee's income exceeds $800 and includes more than $300 of unearned income (such as
dividends), and (2) 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.
Social security tax savings, too. If your business is not incorporated,
you can also save some self-employment (i.e., social security) tax dollars by shifting
some of your earnings to a child. That's because employment for FICA tax purposes doesn't
include services performed by a child under the age of 18 while employed by a parent. For
example, let's say a sole proprietor who usually takes $120,000 of earnings from the
business pays $5,350 to her 17-year-old child in 2007. The sole proprietor's
self-employment income would be reduced by $5,350, saving her $155.15 (the 2.9% HI portion
of the self employment tax she would have paid on the $5,350 shifted to her daughter).
This doesn't take into account a 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 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 parents.
Note that there is no FICA or FUTA exemption for employing a child if your business is
incorporated or a partnership that includes non-parent partners. However, there's no extra
cost to your business if you're paying a child for work you'd pay someone else to do,
Retirement benefits. 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, a SEP
contribution can be made for the child up to 25% of his or her earnings but the
contribution cannot exceed $45,000 for 2007. 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 2007, that figure is $52,000 for a single