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Income
Shifting |
Business
owners 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 retire-ment plan contributions
for your child. 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 36% 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 $4,550 during the year (and doesn’t
have earnings from other sources). The business person saves
$1,638 (36% of $4,550) in income taxes at no tax cost to his
daughter, who can use her $4,550 standard deduction for 2001
to completely shelter her earnings. In addition, the daughter’s
earned income would allow her to contribute $2,000 to a Roth
IRA.
The business person could save an additional $720 in taxes if
he could keep his daughter on the payroll for a longer period
and pay her an additional $2,000. She could shelter the additional
amount from tax by making a tax-deductible contribution to a
traditional 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 or 15%, instead of being taxed at
the parent’s higher rate.
Keep in mind that bracket-shifting works even if the child is
under age 14 (although you would probably be paying less for
a younger child’s labor). The kiddie tax only causes a
younger child’s investment income in excess of $1,500 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.
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 $750 and includes more than $250
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 does not include services performed by
a child under the age of 18 while employed by a parent. For
example, let us say a sole proprietor who usually takes $120,000
of earnings from the business pays $4,550 to her 17-year-old
child in 2001. The sole proprietor’s self-employment income
would be reduced by $4,550, saving her $131.95 (the 2.9% HI
portion of the self-employment tax she would have paid on the
$4,550 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 is no extra cost
to your business if you are paying a child for work you would
pay someone else to do, anyway.
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.
If you have any questions about how these rules apply to your
particular situation, please do not hesitate to call. Also,
keep in mind that some of these rules about employing children
(such as the maximum amount they can earn tax-free) change from
year to year, and may require your income shifting strategy
to change, too.
June 15, 2001
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