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Tax Breaks for Hiring Your Children in Your Family Business

by
Tom Gargiulo, E.A.
on
6/12/2016
Tax Breaks for Hiring Your Children in Your Family Business

If you are a business owner and you have children, then it may work to both your advantage and to theirs to hire them over their summer break from school. There are numerous benefits to exploring this option. Children who are old enough and capable of doing the work can help fill in for existing employees as they take summer vacations, and will appreciate the opportunity to earn some money and get some legitimate work experience.

It allows you to hire people who you know and trust, and who are familiar with the business and your values, and even gives the kids a chance to see and appreciate how hard you work, and what the business is all about. It's completely legitimate as long as the work that you assign them to do is valid and the amount that you're paying them is appropriate to what they are doing and how much they are working. Here are some of the biggest benefits to hiring your children. 

Reduce Self-Employment Income Tax

When you are a self-employed individual and you pay your child a salary, it reduces your total taxable income (which you would have spent to support the child) and shifts it to the child, who is generally taxed under different rules and at a lower rate. As long as a child is a student under the age of 24 or is under the age of 19, they will be considered a dependent and their income is taxed at the kiddie rate if they have over $2,100 in investment income. 

What this means is that they can use a lower standard deduction of $1,050 despite being taxed at the parent's top marginal rate, but the rules for how children's earned income are not as punitive. Their earned income will be taxed at the child's marginal rate, which means it will to determine the tax rate it will be reduced in one of two ways –either by the amount of the earned income plus $350, or the standard deduction. Either way, the tax rate for the child is less while also lowering taxable income for the parent, and if the child makes anything up to $6,300 they won't be taxed at all. For those who make more than $6,300, the tax rate for the next $9,275 is just ten percent. 

To understand how this works, consider this example: You are the owner of an unincorporated business with a tax bracket of 25%. If your child has no investment income and you hire them and pay them a salary of $11,800 during the course of the year, you reduce your own taxable income by that amount. This results in a tax savings of 25% of $11,800, or $2,950, while your child is only taxed on $5,500 because the $11,800 will be reduced by the $6,300 standard deduction. Your child's tax is calculated at 10% of $5,500, or $550. That's a big tax savings for a family. 

Avoid Paying FICA TAXES and Unemployment Taxes

Depending upon the age of your child, you have the possibility of avoiding having to pay FICA – Social Security and Hospital Insurance (Medicare) when you hire them. This is because parents who own unincorporated businesses are not required to pay these taxes on wages paid to a child under the age of 18. Neither the child nor the parent has to pay FICA taxes, and this represents additional savings beyond the ability to lower the amount of the business' income subject to self-employment tax.

Here's an example of how this works using the same pay scale as referenced previously. If the business has a profit of $130,000, the $11,800 that you pay your child who is under the age of 18 not only reduces your self-employment tax burden, but also the amount that you have to pay for Hospital Insurance by $316. This is calculated by taking 2.9% of the $11,800 and multiplying it by the self-employment hospitalization factor of 92.35%. Additionally, if your business' profits fall under the maximum self-employment income rate subject to Social Security tax, you can add an additional 12.4% savings for the Social Security taxes that you would have owed on another employee.

The same principal applies to federal unemployment tax which is exempt for earnings that a parent pays to their child under the age of 21. Not only does this exemption apply for a sole proprietorship, but also when the parent's business is a partnership as long as the parents are the only partners. 

Retirement Benefits Along with Tax Savings

Finally, if you employ your child for an extended period of time, or they earn enough money that they choose to put it into their own traditional IRA, they have the advantage of being able to take up to $5,500 and use it to make a tax-deductible contribution. Your business may even wish to offer them the benefits offered by your internal retirement plan if they are eligible.

By carefully leveraging the maximum deductible contribution into the IRA along with the standard deduction, your child could come out of their summer employment having paid no taxes on $11,800 or earned income. In fact, when you look back at the first example, where the child can realize tax savings of $550 by investing in a traditional IRA, it may make more sense to simply put the money into a Roth IRA. Though they would lose the $550, the Roth would likely far exceed that as it appreciates over the child's lifetime.

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Tom Gargiulo, E.A.

Tom Gargiulo, E.A.

Tom Gargiulo, E.A. is a tand Quickbooks accounting professional based in St. Petersburg, Florida. Tom is a Member of the National Society of Tax Professionals and has been Enrolled to Practice before I.R.S. since 1986. Specializing in Quickbooks Accounting, Consulting and Training, he has many QuickBooks certifications. National Tax, Accounting & Financial is a family business started over 25 years ago. If you could summarize our firm in one word, it would be "personalization". Our firm gets to know our clients as people and uses our personalized service to best meet their needs in all facets of our business. This translates into savings for our clients. We bring unique solutions to complex problems by applying years of experience and the latest technologies. We can assist you with your tax preparation and accounting needs.

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