There are many strategies to reduce tax liability, however we want to share one of our favorites. If you have children and own a business this one may make sense for you.
The IRS allows the deduction of a reasonable allowance for salaries or other compensation for personal services rendered. What this means is that if you have children who perform work for the business they are entitled to compensation, which can lead to major tax savings.
When you hire your children and place them on payroll, you receive a deduction for the wages you pay them. If you pay them under the standard deduction amount, this then will take their taxable income to zero resulting in no tax due for them as well. If you operate as schedule C or as a partnership where both partners are parents of the child and your child is under 18, neither FICA (Social security and Medicare) nor FUTA (Federal unemployment), tax applies as well! From there we recommend clients to then set up a Roth IRA or a 529 plan helping pay for college or setting your child up for retirement. Roth IRAs also allow you to pull all contributions out at any time penalty free if needed and have some other exceptions that eliminate the 10% penalty such as using up to $10,000 for first time home buyers and using the funds for qualified higher education expenses.
If your business is structured as a partnership with a non-parent partner, an S corporation, or a C corporation, you may still employ your children leading to large tax reductions however payroll taxes are applicable.
Example:
If your business profits $250,000 before this applicable deduction, you file jointly and have two children. Placing both children on payroll and paying them each $16,000 translates to tax savings of around $9,000. Additionally, if you then take this money, invest it into a Roth IRA from ages 10-18 and don’t contribute another dollar again, assuming an 8% return, by 59.5 this money will have turned into over $2 million dollars.
Compliance:
Parents employing their children are exempt from most labor laws. The Fair Labor and Standards act allows children to work at any time of the day and for any number of hours. Tax Law has also established that no minimum age is required, however it is crucial that the work the child is performing is reasonable. A 2-year-old child most likely is not able to do work on the computer or help around the office meaning this would not hold up in court. However, a 13-year cleaning up the shop would.
In the case of an audit to build bulletproof evidence you should:
1.) Obtain an employer number – If you do not have any other employees, you will need this in order to have employees on payroll.
2.) Require a time sheet – You child should complete this weekly to document the number of hours worked.
3.) Document pay scale – If you pay your child minimum wage this is not needed, however higher rates require proof that the wages you are paying are reasonable.
4.) W-2 – You should always pay your child through payroll. The W-2 wages are what exempts the child if under 18 from paying payroll taxes.