If you have a family-owned business, consider employing your children. You may teach them responsibility and gain some tax savings along the way.
Regardless of the form of business organization, you may be able to convert some of your high-taxed income into tax-free or low-taxed income by employing your children. Of course, for the wages to be deductible, the work done by your children must be legitimate, and the pay must be reasonable.
For example, suppose parents in the 33 percent marginal tax bracket for 2013 hire their teenager full-time during the summer and part-time into the fall. Assume the teen earns $6,100 from the business and has no other income during the year.
The parents save $2,013 (33 percent of $6,100) in income taxes (however, employment taxes may still apply; see below), and the teen uses the $6,100 standard deduction for 2013 to completely shelter the earnings. Even if the child's earnings exceed the standard deduction, family taxes will still be reduced because the excess will be taxed to the child beginning at a rate of 10 percent instead of at the parents' higher rate.
Are there "kiddie tax" implications? The so-called kiddie tax applies to a child who does not file a joint return for the tax year and has either:
- Not reached age 18 before the close of the tax year, or
- Reached age 18 or is a full-time student age 19-23 with earned income that does not exceed half of the child's support.
Employing a child age 18 or a full-time student age 19-23 could cause earned income to exceed more than half the child's support, thereby eliminating the kiddie tax. There is no earned income escape hatch from the kiddie tax for children under age 18.
However, even if the kiddie tax applies, it only causes a child's investment income in excess of $2,000 (for 2013) to be taxed at the parents' marginal rate. It has no impact on the child's wages and other earned income.
Should the child begin a retirement savings program? Additional savings are possible if the child earns more and deposits the extra wages into a traditional IRA. For 2013, the child can make a tax-deductible IRA contribution of up to $5,500. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child痴 age, and the number of hours worked.
Between the child's standard deduction and IRA contribution, a child can earn up to $11,600 in 2013 without paying any income taxes.
Must we withhold income taxes? Regardless of how the family business is organized, it probably will have to withhold federal (and maybe state) income taxes on the child's wages. But it's possible for an employee who had no federal income tax liability for the prior year, and expects to have none for the current year, to request zero withholding through increased exemptions on Form W-4.
However, exemption from withholding cannot be claimed if the employee:
- Has income that exceeds $1,000 and includes more than $350 of unearned income (such as interest or dividends) and
- May be claimed as a dependent on someone else's return.
Keep in mind that the child probably will get a refund for part or all of the withheld tax when the child files a return for the year.
What about other payroll taxes? Employment for FICA tax purposes does not include services performed by a child under the age of 18 while employed by a parent. This rule can generate some savings for a parent who runs an unincorporated business, including a disregarded entity such as a "single member limited liability company," by reducing the parent's self-employment tax without causing the child to pay the self-employment tax. A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by the child's parent.
If a partnership consisting solely of a child's parents employs the child, the FICA and FUTA exemptions also apply. However, there is no FICA or FUTA exemption for employing a child in an incorporated business or in a partnership that includes non-parent partners. The children are subject to the same rules that apply to all other employees.