One unique aspect of owning your business is the ability to hire your children. Whether doing so makes sense is more than a business decision. The answer depends a great deal on your intentions for passing the business to future generations, the child’s interest and aptitude, and feelings about how much a parent should “help” a child and how much they should “make it on their own.” However, some real benefits are available when you employ your children.
Usually, children (especially minors) are subject to lower tax rates than their parents. In this case, shifting taxable income away from the parents and to their children is an effective way to save on payroll taxes.
A practical example
Imagine that Mr. Smith, a sole proprietor, owns a construction business called Smith Builders. As a sole proprietor, all of the net income from the business is reported on his personal return and is subject to self-employment tax. At the end of the year, Smith Builders reports a profit of $80,000, which will result in a tax of $31,304 which is calculated as follows:
However, Mr. Smith has chosen to employ his 16-year-old son for the summer. His son earns $5,000 over the course of the summer and this is his only income. Mr. Smith’s son would not have a tax liability on the $5,000 he earned because it is less than the 2015 standard deduction of $6,300. By paying his son $5,000, Mr. Smith reduces his business’s net income from $80,000 to $75,000 and, as a result, his personal tax liability by $1,957 as calculated below.
As a sole proprietor, Mr. Smith is also entitled to additional savings due to not having to pay Social Security, Medicare, or FUTA taxes on the wages paid to his son. Social Security and Medicare taxes are not imposed on earnings paid for services performed by a child under the age of 18, and FUTA taxes are not imposed on earnings paid to a child under the age of 21.
Note: The payroll tax exemption only applies to unincorporated businesses and partnerships whose members consist solely of the child’s parents. The self-employment tax savings would also only apply to unincorporated businesses and partnerships. However, the income tax savings would apply to any business structure.
Consider retirement savings too
In the above example, the wages earned by the child were below the 2015 standard deduction. However, the wages paid to the child do not have to be below the standard deduction to derive tax savings. Let’s use the same facts as the above example, but with a few changes.
Mr. Smith would like to see his son begin an IRA. To help his son do this, Mr. Smith decides to keep his child as a part-time employee after the summer ends. As of December 31, Mr. Smith’s son has earned $10,000 (the amount necessary to contribute the maximum amount to an IRA). Mr. Smith will reduce his personal tax liability by $4,200 (25 percent of $10,000 plus self-employment tax savings of $1,700) and Mr. Smith’s son will not incur a tax liability as detailed below:
IRA deduction (5,500)
Standard deduction (6,300)
Taxable income $0
What is the Kiddie Tax?
Kiddie Tax is a tax that is applied to a child’s unearned income (investment income) in excess of $3,100. Kiddie Tax is applied to a child in the following situations:
- The child is under the age of 18 at the end of the year or
- The child is over the age of 18 (or a full-time student age 19-23) and his or her earned income does not exceed one-half of the child’s support.
Wages are earned income, so they are not subject to the Kiddie Tax.
Take advantage of the tax benefits
Many potential tax benefits are available by employing a child in the family business. First, the business owner may shift income from the parent’s higher tax rate to the child’s lower tax rate. Second, FICA and FUTA tax savings may be realized for both the child and the parent. Finally, the business owner may begin the child’s retirement savings process and save on taxes now.
Tax law is complex. Call on Yeo & Yeo to identify individualized strategies that will minimize tax liability now and in the future. Tax planning is vital for your family … and your family business.