As a business owner, hiring your children has always been a great tax planning strategy. However, with the passing of the Tax Cuts and Jobs Act, this shift of income is better than ever. With the 2020 single taxpayer standard deduction set at $12,400 (compared to $6,350 in 2017), a child can earn nearly double what they would have made prior to 2018 and potentially pay little to no income tax on the earnings (for federal purposes). On the business side, the parent will take the wages paid as a deduction, ultimately lowering the business’s taxable income. Below is an example to show the potential tax savings available for owners that meet the requirements to implement this strategy.
Suppose a profitable business owner operating as a sole proprietor is in the federal 22% tax bracket with a state tax rate of 4.25%. He hires his 17-year-old daughter to help part-time with office work in 2020. The daughter earns $12,000 from working with her dad and has no other earned or unearned income. For simplicity, we will ignore the self-employed and qualified business tax deduction, as well as any other state tax deductions or exemptions. In this scenario, by hiring and paying his daughter, the business owner saves $4,845 ($1,695 self-employment + $2,640 federal ordinary income + $510 state) in taxes at little tax cost to his daughter. Even if the child’s earnings exceed that of the standard deduction, these additional earnings will be taxed to the child beginning at a federal rate of 10%.
REMINDERS: 1) Children under age 18 are exempt from FICA (social security and Medicare) taxes if they are employees in a parent’s unincorporated business (sole proprietorship) or a partnership in which each partner is a parent of the child. 2) A dependent’s standard deduction can be used to offset the child’s W-2 earnings (up to $12,400 for 2020). 3) Wages paid by a parent to a child must be for work done in connection with the parent’s trade or business. The wages must be legitimate and reasonable in relation to the services rendered. Owners should keep detailed records of the child’s employment, including payroll records. 4) If eligible, a child may be able to contribute to a retirement account. 5) Business owners must abide by child labor laws for federal and state purposes. The Federal Labor Standards Act (FLSA) restricts the type of work that can be performed by employees under the age of 18.
Keep in mind, our tax laws change just about every year. This may require a taxpayer’s income-shifting strategy to change as well. Also, the purpose of this article is to suggest general tax planning ideas that may be appropriate in certain situations. The information and strategies presented may not apply (or be beneficial) to all taxpayers. Before implementing any ideas or strategies discussed, we encourage you to contact our office.
We will be happy to assist you!