Hiring your kids may provide tax advantages Tax Matters by David A. Katzman If you operate a business, you may benefit in several ways if you hire your children to work with you. For example, if you plan to pass your business down to the next generation, then hiring your children will help prepare them for their future role as owner. Of course, this decision will depend on the type of business you operate and your children’s interests and abilities. If it makes good business sense, however, then hiring your children may also offer several tax advantages. Generally, children pay taxes at a lower rate than their parents, so hiring your children allows you to shift some of the overall family tax burden to them. Many taxpayers believe such income-shifting is no longer viable because of changes to the federal tax code, which generally requires unearned income for children under age 24 to be taxed at their parents’ tax rate. This change is generally referred to as the Kiddie Tax. However, it does not apply to parents who hire their children to work in a family business. Wages are earned income, and the Kiddie Tax only applies to unearned income. In addition to generally lowering the tax rate paid on the money earned by your children, you may also gain a larger tax deduction. The standard deduction for a child claimed as a dependent for 2008 is $900. However, dependents with earned income are treated differently. You are allowed to deduct the dependent’s earned income plus $300, up to a maximum of $5,450. Additionally, another $8,025 in income would be taxed at the ultra low 10 percent rate. Depending on the structure of your business and the age of your children, you may also be able to reduce your payroll taxes. If you operate a sole proprietorship or a partnership that includes just you and your spouse, you may take advantage of some exemptions when you hire your children. For example, employing children under age 18 means they are exempt from social security, Medicare, and FUTA unemployment taxes. If your children are over 18 but under 21, they are exempt from FUTA only. You lose these exemptions if you operate as a C or S corporation or have additional partners. Paying wages to your children also effectively cuts your self-employment taxes because the wages you pay are expenses, so you are able to subtract them before calculating the amount of self-employment taxes you owe. When you hire your children, you may also open Individual Retirement Accounts (IRAs) for them. This could further lower your taxable income and may provide a huge future benefit for them. If you paid your child at least $5,000 for the year, you may fully fund either traditional or Roth IRAs for that child. The Roth IRA may be a particularly strong option because of the structure of these accounts. Your child will not receive a reduction in tax on Roth IRA contributions, but the lost tax savings will likely be minimal because of your child’s tax bracket. Earnings from a Roth IRA, on the other hand, are tax-free. Another advantage is the ability to eventually withdraw Roth IRA contributions without penalties, since taxes were already paid. This means your child could use the contributions, but not the earnings, to fund college costs without paying tax or penalties. While employing your child can bring many tax-based advantages, there are some requirements with which you should comply. For example, you should take care to pay wages to your child that are comparable to those wages paid to non-related individuals for the same work. Additionally, the tasks you assign your child and the amount of time worked should be realistic given the child’s age and skill levels. If you fail to follow these requirements, the Internal Revenue Service (IRS) may question the legitimacy of your arrangement. David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.