Small Business Taxes & ManagementTM--Copyright 2018, A/N Group, Inc.
Does it make sense to put your children on the payroll for a summer or part-time job? While there are certainly tax implications, there are business and personal issues to consider too. Before digging into the details, let's discuss some general issues. First, is the child going to get paid? If he or she is going to occasionally help you out in your home office, doing some filing, stuffing envelopes, etc. and the work is minimal, you might want to bypass the formalities and just put something extra in his or her allowance. Paying a salary, withholding, etc. can be a nuisance if you have no other employees. On the other hand, adding him or her to an existing payroll is usually easy.
Second, can the child do the work? You're a heavy equipment contractor doing business as a corporation. State law requires any one working in a dangerous industry to be at least 17. Your son is only 15 and, since you use a bookkeeping service for all your paperwork, the only job is in the field. Or you claim your 10-year old daughter works in your autobody shop. If audited, the IRS is quick to investigate family members on the payroll. If it's clearly not possible the child could have performed the work as claimed, the IRS will simply disallow the payments. And the IRS could interview current or former employees to check your story.
Sole Proprietorship or Other Entity?
How you do business makes a difference here. Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the business is a sole proprietorship or a partnership in which each partner is a parent of the child (i.e., your and your spouse are both members of an LLC and there are no other members). In addition, the payments are not subject to federal unemployment tax (FUTA) if the child is under 21. In any other situation, the payments are subject to FICA and Medicare taxes as well as FUTA.
For example, Kristin works for her father's LLC that's owned by her father and uncle. The ownership by the uncle means the partnership doesn't qualify and her wages are subject to FICA and Medicare.
FICA and Medicare taxes aren't insignificant. There are two portions--the employer's portion is 7.65% of his or her salary; the employee's portion is a like amount. Since we're looking at a family situation, the total cost to the family is 15.3% of the salary. Half of that (the employer's portion) is deductible. However, even if you're in the 40% bracket (federal and state), the out-of-pocket cost will be a little over 9%. On $5,000 of salary that would be about $460. If you're in a lower tax bracket your out-of-pocket would be higher because the deduction is worth less. If you have multiple businesses and at least one is operated as a sole proprietorship and your child is under 18, consider having the sole proprietorship employ the child, if possible.
Computing the Tax Savings
Tax savings result from the switching of income from a high bracket (yours) to a low bracket (your child's). While that's true most of the time, it's not unheard of for a business owner to sustain losses that put him or her in a low bracket, so it pays to check.
Even if your child is still your dependent, he or she can claim the standard deduction. That's equal to $350 plus earned income, but not more than $12,000 (2018 amount). That means if he or she has no other income, the first $12,000 is not subject to tax. (2018 amount; go to www.smbiz.com/sbrl001.html for the current year standard deduction.) We've ignored state taxes on your child's income in the discussion below. While the rules vary widely, state taxes are likely to be minimal.
The actual savings depends on your tax rate, your child's rate, and the entity under which the business operates. We'll give you a rundown on the different entities. In the discussion immediately below, we'll assume the child's only salary is from your business and it's $5,000.
Regular Corporation. If you do business this way the corporate tax rate is now a flat 21 percent on all income. The child will have income of $5,000, none of which will be taxable to him or her. The corporation gets a deduction for $5,000, saving $1,050 in taxes. Social security taxes will cost the corporation about $302 ($382.50 in FICA taxes less the benefit of a tax deduction). Your son or daughter will have $4,617.50 (net after their share of social security taxes) in their pocket; the corporation will be out-of-pocket only about $4,252. The government has picked up about $740 of the amount you've given your child.
Partnerships and LLCs. Here the situation depends on the tax rates of the partners. We'll assume the tax savings go to you alone. In this situation assume that you're in the 24% bracket for federal purposes; 5% for state. In partnerships and LLCs your share of the profits is subject to the self-employment tax (15.3%) up to the $128,700 (2018 amount) limit. There is no limit on Medicare taxes and there's an additional 0.9% tax on individuals with higher income ($200,000/$250,000). Chances are you won't break the limit, so the $5,000 you pay your child will reduce the partnership's income and, thus, your self-employment taxes by 15.3% of $5,000 or $765 as well as reducing your taxable income. In addition, you'll pay $382.50 in social security taxes (0.0765 X $5,000) on your child's salary. Your effective tax rate is 24% for federal plus 5% for state and about 12.8% for the self-employment tax (it's 15.3%, but you get to deduct half of it on your personal return) or 41.8%. Thus, the $5,382.50 (salary plus employer's share of social security taxes) will save you $2,250 in taxes. Your out-of-pocket cost will be $3,132.50. Your son or daughter will have $4,617.50 after social security taxes ($5,000 less $382.50). To find the total tax in other brackets you're pretty safe in just adding your federal and state rates and then add 12.8% for the self-employment tax. In the top brackets the benefits are a bit more; in the lower brackets, less.
Sole Proprietorships. The result would be similar to that for partnerships and LLCs, unless the child is under age 18. Then we don't have to worry about social security taxes. In that case the tax benefits are a bit more.
S Corporations. The computation here is similar to partnerships and LLCs, above, but the child's salary and social security taxes will only reduce your social security taxes if you reduce your salary by a like amount. Since that's unlikely, we won't use that assumption. Again assume the 24% bracket for federal purposes and 5% for state. The cost of paying your child is $5,000 plus the $382.50 in the employer's portion of social security taxes or $5,382.50. The tax savings would be 29% of that or $1,561. Thus, your out-of-pocket would be $3,821. Your son or daughter will have $4,617.50 after social security taxes ($5,000 less $382.50). The savings here are less. Why? Because there's no saving from the self-employment tax, the overall tax rate is less. When the tax rate is less the government picks up less of the cost.
You can see from the situations above, the biggest savings occur if you're doing business as a sole proprietorship, partnership, or LLC since the self-employment tax boosts your tax rate resulting in larger savings from the deduction.
Clearly, we've made it simpler than in real life. Fortunately, your savings could be more. If you're in the 37% bracket and your state taxes are 7%, the savings will be larger. The rest of the discussion assumes you're doing business as anything but a C corporation.
There are additional, hidden savings. By paying your child you reduce your own adjusted gross income (AGI) in all but a C corporation (unless you reduce your salary). There are many tax benefits and limitations based on your AGI. For example, the child care credit is phased out for higher income individuals as are itemized deductions, the $25,000 allowance for rental real estate losses, etc. To the extend you can shift income to your children, you can reduce or avoid these phaseouts.
While the discussion above was aimed at a summer job for your child still in school, the approach can have benefits for older, working children. The benefits will be less because they'll be paying taxes on the income if it's about the standard deduction, but they can still be significant. For example, if you're in the 37% bracket and can transfer income to your daughter in the 12% bracket by employing her part-time in the business, the 25 percentage point spread could save considerable tax dollars. Of course, as her and your brackets converge the savings become less.
By the Book
Will it work? The IRS has gone to court and won some and lost some. You can win if you're careful. This is another one of those the devil is in the details. First, you've got to put the child on the payroll. If you're a sole proprietorship or LLC without any employees you'll have to start filing Form 941 (employment taxes) quarterly, filing state employment tax returns, and paying state unemployment insurance. You'll probably need workers' compensation insurance. If you don't currently have employees, this may be more of a hassle than it's worth. If you already have employees, adding your son or daughter shouldn't cost much.
Don't try to claim the child is an independent contractor. That's often tough to do even when the worker is older, experienced and has some professional credentials. It's highly unlikely to fly here.
Make sure the child is qualified to handle the job. The IRS is going to be skeptical. You'll be on firmer ground if you've hired individuals close to your child's age for the job in the past, or others in the industry have done so. If the job requires special skills, make sure the child has them and you can document that. In an old case the Tax Court sided with the taxpayer in allowing a deduction for a child of seven (and his only slightly older siblings). The taxpayer had a motel and the children swept the walkways, took out trash, cleaned rooms, etc. The more skill required for the job, the more documentation you should have.
Pay the going salary. Don't pay more than you would to an unrelated party who would have filled the job. If you never had anyone in that position, ask around. An excessive salary is sure to raise a red flag.
In one case the taxpayer lost points (and ultimately a deduction) for (1) failing to pay employment taxes and file information returns with respect to the child; (2) paying the child a flat amount determined at the beginning of the year that was not based on the services actually performed; (3) a lack of correlation between the dates and amounts of payments and the hours allegedly worked by the child; (4) failing to maintain adequate records of the child's hours worked and amounts earned; and (5) compensating the child for services which are in the nature of routine family chores. And, although it seems obvious, give your child a check. Don't pay him or her with a trip to a theme park, a new bike, etc. Even when you pay by check you may have to rebut the supposition that payments made to dependent children are in the nature of support and nondeductible.
The jobs the child does should be clearly work related. If you have a regular place of business (office, laundromat, motel, farm, etc.) that may be easy. If you work out of your house, that may be more difficult. Don't give them jobs that aren't work related but that would free you to work. For example, having your daughter do the laundry to free you up to spend time calling customers. It may be valuable to you, but payments for that service aren't any more deductible than hiring a housekeeper.
Document everything. Keep a log of days and hours worked, what was done, etc. Do it on a daily basis. Reconstructing six months or a year later won't work. This doesn't have to be ultradetailed, but it should be specific. For one taxpayer a diary and testimony of an unrelated employee convinced the court that the minor earned the salary.
What about your 27-year old daughter with her MBA? The same rules apply, although you don't have to document her work as carefully. Make sure you can show a reasonable salary and that he or she performed actual work. The same applies to your father or mother. There's often an advantage here to putting them on the payroll. You may not need to cover them with health insurance (they may be on Medicare) and they're probably in a lower tax bracket. Make sure they can do the job, especially if there are physical requirements.
As always, check with your tax advisor before committing.
Copyright 2018 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
--Last Update 05/31/18