Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part IV. Business Income and Deductions
Chapter 21. Employing Family Members
These “Child Labor Laws” Can Really Lower Your Taxes
One of the greatest tax benefits of owning your own business is finding ways to transform personal, non-deductible expenses into deductible business expenses. A great non-tax benefit of owning your own business is that you are the boss and get to decide how you run that business— including whom you hire as an employee. In this chapter these two benefits meet and combine to form a powerful tax-saving strategy. Hiring family members as legitimate employees of your business can bring significant savings on your tax return. The tax available to you will depend mostly on what member of your family you employ, and as such, the strategies in this chapter are broken up into three main categories:
· Employing children
· Employing your spouse
· Employing your parents
Does little Johnny need to learn how to work? Does Suzie need something to do with her time? Do you need a way to reduce your taxes? If so, these needs could be combined for a match made in tax heaven. Employing your children in your business can save money in both income taxes and payroll taxes.
At the foundation of this strategy is something known as income shifting—taking income from an individual in a higher tax bracket and moving it to someone in a low tax bracket. This is especially effective for immediate family members who would already be sharing in each other’s income. Used wisely, this strategy can save a lot of money.
Example Martha has a bookkeeping business based out of her home. While some of the work she does requires a high level of skill and training, much of it is mundane, such as filing, opening mail, and shredding and shredding documents. Martha has a 12-year-old daughter, Ruby, who needs to earn money for extracurricular activities and who could easily perform the mundane activities of Martha’s business, freeing Martha up to do more work that she can bill for.
Martha and her husband are in the 28% federal tax bracket. If Martha hires Ruby to work for her 10 hours per week, at $12 per hour, Ruby will earn about $6,000 per year. By shifting this income to Ruby it would save Martha $1,680 in federal income taxes per year. (If you add to that the average state tax of around 5% she will have saved around $2,000 in total income taxes.) What is more, Ruby would not have to pay any income tax on that money either (more on that later).
The savings of this strategy do not stop with federal and state income taxes. Sole proprietors, as well as husband–wife partnerships (not other partnerships or business entities), who employ their own children who are younger than 18 years old are not required to pay any Social Security, Medicare, or unemployment taxes on those wages! This is an additional savings of up to 15.3% on that shifted income. To realize the full savings, the business-owner-parent’s income needs to be below the cap for the Social Security tax, which is $117,000 in 2014.
Example Martha’s net income from her bookkeeping business is around $80,000 per year. If Martha pays Ruby $6,000 per year, that amount will be deducted from Martha’s income, saving her $918 in self-employment taxes. In addition, since Ruby is Martha’s daughter, she will not have to pay payroll taxes on those wages, so the $918 is a true savings. When added to the income tax savings in the previous example, Martha will save almost $3,000 in taxes by hiring her daughter and paying Ruby $6,000 in wages. In essence it is costing Martha only $3,000 to give her daughter $6,000 (while giving her work experience to boot).
This strategy has its maximum benefit when the child owes no tax on the income that he or she receives. A dependent child cannot claim a personal exemption on a tax return, but is able to claim the standard deduction. Because of this, the first $6,200 of income to the child (the amount equal to the standard deduction in 2014) is completely tax-free.
If you would like to shift more tax-free income to your child, you could do so by having him or her make contributions to an IRA. If the child contributes the maximum $5,500 to a traditional IRA during the year, she could earn $11,700 before paying any tax. If you have even more money available to pay your child you can use a 401(k) instead of an IRA and pay your child as much as $23,700 ($6,200 in take-home pay plus $17,500 in 401(k) contributions) before she pays a penny in tax! You could also make employer matches for those contributions and profit sharing contributions—all of which are deductible business expenses. If you have two or three children, the potential tax savings becomes very significant.
Example After two years of being able to focus solely on the income-generating aspects of the business, Martha’s income and workload have increased significantly. Martha decides to train Ruby (who is now 14) to perform bookkeeping tasks so that Martha can keep up with the workload of the business. As she performs higher-level skilled work Martha can legitimately pay her higher wages for the work that she does. Ruby works 18 hours per week (2 hours per weekday and 8 hours on Saturday) and earns $25 per hour for her work, for a total of $22,500 per year. Ruby keeps $6,200 to pay for her activities and puts the remaining $16,300 into her 401(k).
Martha also hires her son, Tommy, to do the administrative office work that was previously done by his sister Ruby. Because the business has grown, Martha needs him to work 15 hours per week at $12 per hour, for a total of $9,000 per year. Tommy keeps $6,200 to pay for his activities and puts the remaining $9,800 in his 401(k).
By hiring her two children, Martha has shifted $31,500 ($22,500 for Ruby and $9,000 for Tommy) of her highly taxed income to her children, who pay zero tax. In doing so, she has saved $15,215 in taxes (28% federal, 5% state, and 15.3% payroll).
As you read these examples you may have some concern about putting so much money into an IRA or 401(k) for children who will not be able to touch that money for 40–50 years (when they are 59½). Never fear! When the children turn 18 and head off to college they will leave their employment with your business and at that point can roll the 401(k) funds into an IRA, and then use the money, penalty-free, for some of their most important early-adulthood expenses.
There are several opportunities for them to use the IRA money without paying a penalty tax. First, they can use the money for their education expenses. Second, they can use the money to pay for their medical expenses. Third, they can use some of the money (up to $10,000) to buy their first house. In all of these cases they will be able to withdraw funds from the IRA without penalty. They will pay income tax on the money withdrawn, but that will likely be at a very low tax rate during their college and early working years. Using this strategy you can permanently shift income to a significantly lower tax and use that income to pay for things, such as college, that you needed to save for anyway. In fact, even if the child uses the money for other reasons, the penalty tax is only 10%, which is less than the payroll taxes you would have otherwise paid.
Another concern that may have crossed your mind is that you don’t have that kind of disposable income available to pay your children. Never fear! You can work out an agreement with your children that they need to use a portion (or all) of the income to pay for things that you would have spent money on anyway, such as clothing, school supplies, and extracurricular activities. In that way you are not really using any money that you wouldn’t have already spent, and you are saving taxes in the process. Perhaps you could pass on the tax savings to the children as their compensation—giving them money to for what they need and being in the same position financially as you were before. It is a win–win situation.
Caution If your child is using the income to pay for things that would have otherwise been your responsibility to pay for as a parent, there is one thing to be careful of. You must be sure that the things the child pays for do not add up to more than half of his/her support. If that happens you could lose your ability to claim the child as a dependent, which would certainly have a negative impact on your taxes and possibly leave you worse off than if you had not employed the strategy at all. However, if you are paying them a lot of money and most of it goes into a retirement account, you do not need to worry about losing your claim on them as a dependent.
For the IRS and the tax courts to honor this strategy, the child must do legitimate work and be paid a competitive wage. You can’t pay a child $150 to empty the trash and expect such a payment to be upheld in court. As long as the child is doing work that you would legitimately pay someone else to do, at a rate that is common in the marketplace for that type of work, you will be safe in claiming the wages as a deduction.
One more consideration is the age of your child compared to the work that you are claiming that he/she performs. If you are paying your five-year-old to do your filing or answer phones, it will probably be met with some skepticism. Tax courts have upheld wages for children as young as seven years old doing menial tasks, such as cleaning. Just be sure that what you are claiming makes sense. It is also wise to keep good records of the time spent each day and the tasks that were performed.
Employing Your Spouse
Employing your spouse in your business does not bring the same level of tax benefits as employing a child. Your spouse’s income will join with your income on your tax return, so there is no advantage for income taxes. In addition, you must pay the payroll taxes on your spouse’s income as well. However, there are two key areas where employing your spouse can save a significant amount of money.
Caution While there are potentially significant tax savings to be found in the following two strategies, both require the spouse to be treated as a legitimate employee. This means that the spouse must be paid wages similar to those be found in the marketplace for similar work. It also requires the spouse to be paid through a payroll system and receive a W-2. In doing so, the spouse will be subject to payroll taxes, which may reduce the overall benefit of the strategies (especially if the business-owner-spouse’s income is above the $113,700 Social Security tax cap). These factors may be outweighed by the total tax savings of the strategies, but they must be considered in the decision.
Health Reimbursement Arrangements
The first opportunity for significant tax savings is with medical expenses. There is an IRS-approved conduit for medical expenses known as a Health Reimbursement Arrangement (HRA). An HRA is a system in which the business reimburses its employees for medical expenses. The employer sets the terms of what will be reimbursed and is fully responsible for its funding (no employee contributions are allowed). Any reimbursements made for qualified medical expenses are deductible expenses for the business.
A self-employed business owner (sole proprietor) is not allowed to participate in an HRA program—at least directly. However, if the business owner’s spouse is employed by the business, he or she would be allowed to participate. If the terms of the program (set by the employer) dictate that reimbursements can be made for the employee, the employee’s spouse, and the employee’s children then, voila! the business owner is now covered by the program as the spouse of an employee!
There are two major tax benefits to using an HRA program. First, medical expenses are deductible from the first dollar spent and not limited by the 7.5% or 10% of Adjusted Gross Income (AGI) floor normally placed on medical expenses claimed as an itemized deduction. Second, for self-employed individuals the deduction reduces income taxes and self-employment taxes, whereas the itemized deduction would not reduce the self-employment tax.
Caution As it currently stands, the Affordable Care Act (aka ObamaCare) puts severe limitations on HRAs beginning in 2014. It will be important to watch for any changes to this law to determine whether this will be a viable tax strategy in 2014 and beyond.
Retirement Account Contributions
The second opportunity for tax savings that comes from employing a spouse in your business is through retirement account contributions. This strategy is really for those individuals who already contribute the maximum $52,000 to an employer-sponsored plan but would like to contribute more if they could. By employing a spouse you open up the opportunity for additional tax savings by having a new account available to contribute additional amounts—up to an additional $52,000 if the spouse’s wages are high enough.
Employing Your Parents
Of all the family members whom you can employ to garner tax benefits, employing your parents is the least tax-beneficial strategy of the three. Even so, there are a few opportunities to save money by hiring your parents.
The first and potentially best opportunity comes about if you are already paying to support your parents. Perhaps they have medical needs or housing issues that they cannot afford and you have agreed to help them out. If you pay for these things out-of-pocket you will probably receive no tax benefit for it. However, if you can hire them to do something for your business, you will receive a tax deduction for their wages. This is a great way to deduct expenses that would have otherwise been non-deductible.
The second opportunity is in a situation in which parents are in the opposite circumstances—those who have all the money that they need for their retirement and are in a low tax bracket (while you are in a higher one). In this circumstance, where your parents don’t need any additional money, you could hire them to do something in your business and they could set the money aside (net of their taxes) in a separate account and never use it. Then, in the future they can give the money to you and your spouse and children in yearly amounts that do not exceed the annual gift-tax exclusion. Or, alternatively, they could leave the amount to you as a tax-free inheritance. In this way you will have shifted income to a family member in a lower tax bracket and then recover the money at a later date with no additional tax.
The third opportunity is rather insignificant, but perhaps still worth pointing out. As an employer you must pay a payroll tax known as unemployment tax. It is 6% of the first $7,000 of an employee’s wages, for a maximum $420 tax per employee (the tax is known as FUTA). If you are a sole proprietor and employ your parents, you do not have to pay that tax on their wages. Again, it is not a significant amount—but at the same time, who wouldn’t want an extra $420 in their pocket? (Incidentally, this tax also does not need to be paid on wages for a spouse or children either).
As is the case with spouses and children, the parent must perform legitimate work and receive reasonable pay for the work that they do. However, in some cases it may be easier to justify a high pay for a parent doing limited work than it would be for a paying a child. For example, if your parent’s profession before retirement was of a nature that his or her knowledge would benefit your business, that parent could be paid as a consultant or advisor to the business. Such work does not require a significant amount of labor or time, but generally demands a higher wage. Just be sure that the fee you pay will be deemed reasonable if it is looked at by a tax court.