One tax strategy many people overlook is their children. The obvious areas are child tax credits and personal exemptions, but these are low hanging fruit. For a business owner, there is another, more lucrative tier. In short, put your kids to work. This is not a yearning for the halcyon days of the 19th century before child labor laws, with children packed into industrial mills like sardines in a can, but rather a tax and college savings strategy focused on a business owner’s own children.
The focus of the strategy is to transfer revenue from the owner’s higher tax brackets to the child’s lower (often 0%) brackets by paying deductible wages from the business to the child. Everything a child earns, up to the normal standard deduction ($6,300 for tax year 2017) will not be subject to federal income tax, as long as it counts as earned income. If the child makes a contribution to a traditional IRA, that number goes up by another $5,500. If the child is under 18 and the business is organized as a sole proprietorship, or a partnership owned by the parents, the child’s wages are also exempt from Social Security and Medicare taxes. If the business has a 401(k) plan in place, the owner may be able to siphon off another $18,000 (as of tax year 2017), plus the plan’s employer match, to the child with no income tax effects, although withdrawals from any retirement plan will still be taxable to the child when received.
These techniques can also help a business owner pay for their child’s education. If the child earns wages and places them in a retirement account, the transfer creates a deduction for the parent’s business and allows the earnings to grow tax deferred. Unlike a gift into a Coverdell (education) IRA or a 529 account, this sidesteps the gift tax issues on the transfer, and allows the eventual tax to be paid at the child’s lower rates upon withdrawal, rather than the parent’s rates now. Part of the reason this planning scenario works is that money withdrawn from an IRA is exempt from the early withdrawal penalty if used for education. While 401(k) plans do not have this option, the child’s employment can be terminated when they begin school, the contents of the 401(k) transferred to an IRA, and then withdrawn without penalty.
Unfortunately, simply placing your children on the business’ payroll isn’t sufficient. They do need to actually work for your business, and child labor laws must be observed. This doesn’t mean their services need to be complex, simply appropriate to what they’re paid. Eight and nine year old children can clean up an office, and older children can perform other duties commensurate with their abilities. Anyone, even infants, can model or act in advertisements. There was a car dealer in the northern NJ area whose children effectively grew up on television. From the moment the oldest could utter the catchphrase “Our dad sells the finest”, until the youngest was in college, they were in business’ commercials every year.
If teaching children respect for money is a concern, this also provides the opportunity, instead of giving an allowance, to allow them to earn their money.
If you have any question on utilizing these strategies, please feel free to contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director