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Archive for Employ Your Kids

Did You Know Employing Your Kids Means More College Savings Options? How Your Children can Use an IRA

By Kim M. Larsen EA CTFS
Friday, February 27th, 2015

You probably already know about, or have at least heard of, 529 plans as an investment option for paying for your child’s college education. But, did you know that if you employ your kids in your business, you actually have an option that other people don’t? Children who are employed by their parent’s company have the ability to use an IRA account to pay for college without penalties. That’s a huge advantage!

How It Works

Depending upon how much your children make working for your business, they may benefit more from either the Roth IRA or the traditional IRA—either one is available for their college savings.

Here are the primary reasons that it’s a good choice:

  • For qualified higher education expenses, such as tuition, books, fees, room and board, and even supplies, a child can withdraw the money penalty-free.[1] As long as the child only withdraws the amount needed for qualified expenses, the ten percent early-withdrawal tax does not apply.[2] Of course, for the traditional IRA, regular federal income taxes will apply. Keep in mind that for some costs, the student must be enrolled at least half time in order to qualify.
  • It’s possible that the IRA won’t be factored in when determining student and parent resources for financial aid decisions. The Free Application for Federal Student Aid (FAFSA) is the financial aid form used by most public higher education institutions. This form does not include a section asking about IRAs because it is not typically an asset that is considered available as an educational resource.[3] However, private institutions are more likely to consider the IRA an educational asset and factor that in.[4] If your student is able to exclude the IRA from FAFSA calculations the first year of college, be aware that any IRA distributions will be counted as income on the FAFSA the next year. That is, money in the child’s IRA is not calculated, but money taken out of the IRA is.[5]
  • The money grows tax deferred. Because this provides your child with a great head-start on compounding interest, you should start your child’s savings early and continue it until age 18. Child labor laws do not apply to children who work for their parent’s business (unless the business is particularly dangerous—check the guidelines if you’re unsure), so your child can start earning as early as they can provide a valuable service to your business. This could be as early as seven years old. Of course, this only works if the chosen investments provide a good return.
  • Here’s an example of 12-year growth for a child who contributes $5,000 annually. A 0 percent annual return gives them $60,000. A 2 percent return equals $68,402. But, a 15 percent return garners a total of $166,760 after 12 years.
  • The account could help to reduce or eliminate the kiddie tax imposed on children’s investment income. The kiddie tax imposes the parents’ tax rates on the child’s income. Let’s say your child earns $6,200 at your business for the year (that is the standard deduction for 2014), and they also received $5,000 in investment dividends ($11,200 total). They would have to pay taxes at your tax rate for the additional $5,000. But, if your child contributes their dividend income into a traditional IRA, then they are left with zero taxable income.
  • Even if the child’s income is too low to be taxable, they can use a Roth IRA to continue growing the money and deferring taxes. Usually taxes are paid up-front for the Roth, but in this case, there are no taxes to pay up-front! That means when your child withdraws money from their basis, they do not have to pay taxes when the money goes in nor when it’s withdrawn. If the child contributes $6,000 every year for 12 years, they’ll have $72,000, none of which they ever have to pay any taxes for (because the yearly contribution is less than the standard deduction)! Of course, any interest earned on that amount will be subject to taxation upon withdrawal. A traditional IRA, by contrast, does not have a tax-free basis because the contributions are tax-deductible.
  • If the child earns more than the standard deduction, they get double benefits. Your child will want to get the tax deduction from contributing to a traditional IRA if they earn more than the standard deduction in combined work income and investment income. This means they get the tax deduction, and the money then grows tax-deferred.

It really does pay to employ your children, and the advantage is certainly not all on your side. You can give them a helpful step towards a financially secure future, including making college more affordable and teaching them valuable lessons about how to grow their money. When choosing an IRA for your child, the Roth IRA is best for those earning less than the standard deduction. Otherwise, you’ll want to defer a larger sum of the taxes by choosing a traditional IRA and reducing (or eliminating) their tax bill.

  1. IRC Sections 72(t)(2)(E); 72(t)(7)(A); 529(e)(3). ↑
  2. Notice 97-60, Section 4. ↑
  3. “ASK THE BIZ BRAIN,” Business p. 007, The Star-Ledger (Newark, New Jersey), August 10, 2009 ↑
  4. “ASK THE BIZ BRAIN,” Business p. 005, The Star-Ledger (Newark, New Jersey), October 11, 2009. ↑
  5. “Roth Can Be Expensive Gift for 16-Year-Old” by Gail MarksJarvis, (Business; Zone C; p. 5), Chicago Tribune, July 8, 2007. ↑
Categories : College, Employ Your Kids, Investments, Tax Planning

Hire Your Kid and Get a Tax Break

By Kim M. Larsen EA CTFS
Tuesday, February 17th, 2015

Do you want to find out a better way to teach your child about money than just giving an allowance? If you own your own business, you can pay your kid in a way that benefits both you and the child when it comes time for taxes. You see, it’s possible to get a deduction by hiring your child to work in your company, and your kid could get the money without paying any taxes! Compare that to paying taxes first (without the deduction) and then paying an allowance out of after-tax dollars.

A Precedent Case

Sally Wilson hired her 13-year-old to work in her proprietorship, and she paid the child $5,700. For doing so, she got back $2,600 from state and federal governments. If Wilson’s business functioned as a corporation, she still could have gotten back $644. This extra money comes from hiring-your-child tax breaks.

Additionally, Ms. Wilson’s child paid zero taxes. That’s because the child can take the standard deduction (instead of itemizing property taxes, mortgage interest, charitable donations, etc.). In 2009, the standard deduction was $5,700 (the total amount of the child’s income). The standard deduction is $6,200 for 2014 and $6,300 for 2015.

Why You Should Hire Your Child

Hiring your child is a great way to teach them about finances, as well as what it takes to work and earn money. Aside from that, your own child can make a terrific employee because you already know and trust them.

There’s an added benefit to this tactic if you plan to help your child pay for college. Legally, your child can put money into an IRA (traditional or Roth) to grow tax-free, and because your child is employed by a parent, they can take out that money penalty free to use for college. This is a big advantage for you and your child.

Considering the $6,200 standard deduction for 2014, let’s look at what would happen if your kid earned $11,200. Zero taxes are paid for the $6,200, and if your child puts the additional $5,000 in a traditional IRA, then zero tax dollars are paid for the entire earnings! That’s right—your kid could nearly double their income and still not pay a single penny in taxes.

The benefits are still impressive even when you pay your child even more throughout the course of the year. Let’s use Ms. Wilson’s example again. If she had paid her child $19,050, she would have received total benefits from state and federal deductions equaling $8,763 (saving 7 percent in state income tax, 14 percent in self-employment tax, and 25 percent in federal income tax). She would keep that money. The child has taxable income only on what’s left after the standard and IRA deductions. The tax would have equaled $1,035, and the child would have kept $18,015 (including what is in the IRA).

You may be wondering, “What about the payroll taxes?” Well, if your business is a sole proprietorship (or partnership owned only by the parents of a child), then payments to a child under 18 are not subject to Social Security or Medicare taxes.[1] Additionally, no unemployment taxes have to be paid by such an entity while the employed child is under 21.[2]

Other Considerations

Perhaps you’ve heard of the kiddie tax, which puts a limit on how much income an underage child can bring home without paying taxes. Don’t worry—it doesn’t apply to this situation. The kiddie tax applies only to net unearned income.[3]

As for age restrictions regarding hiring your child, tax law has none. In fact, in one case that the IRS acquiesced to, a couple hired all three of their children to work at their mobile home park operation.[4] The youngest was 7. What the IRS does care about is that you are paying the children fair wages for services rendered. In this case, it noted that compensation paid to children is only deductible if the amount is reasonable and paid for actual services rendered, and parents may deduct amounts paid to their minor children.[5] That means you’ll have to have documentation proving the wages were fair.

Of course, the IRS will be keeping a closer eye on you to make sure that the child actually is an employee and performing services for the business.[6][7] One way to provide documentation of this is to keep a timesheet for your child’s earned wages. And, here’s an extra tip: don’t try to deduct food and lodging expenses for your child employee. Parents are legally liable for the support and maintenance of their minor children.[8]

Maybe the IRS doesn’t mind, but what about child labor laws? For the most part, parents employing their own children are exempt from child labor laws. According to the Fair Labor Standard Act, parents can have their children under age 16 work for any number hours at any time of day in a business owned solely by the parents.[9] The Department of Labor, however, does have prohibitions about employing children in hazardous jobs.[10] Check their website for a list .

What About Corporations?

The rules for corporations differ, of course. As you saw in the numbers above, if Ms. Wilson had been the owner of a corporation, she would have gotten significantly less in tax benefits. That’s because a corporation is not the mother or father of a child. As a corporation, your business will have to pay unemployment taxes, and the corporation and your child will be responsible for Social Security and Medicare taxes.

If you’re going into business and already have children, you may want to consider the different outcomes of hiring your child when choosing an entity structure. When choosing, keep in mind that hiring your under-18 child for a proprietorship or partnership definitely pays off. But, hiring your under-18 child for an S corporation or C corporation may or may not. It’s important that you run the numbers in those situations.

Ensuring Against Audit

As with any tax strategy, the key to winning your child employee deductions with the IRS is to provide adequate documentation. Here are some tips for providing enough proof:

  • Have an Employer ID—Even if your child is your only employee, you need to get an employer ID number in order to make the employer-employee relationship legitimate. You can do this online or call the IRS at 1-800-826-4933.
  • Track Work with a Time Sheet—Having your child fill out a time sheet is a great way to keep proof of the time they worked and the wages they earned. In one case, Vernon E. Martens hired his four children, but failed to require time sheets and lost out on 80 percent of his deductions.[11]
  • Have Support for Your Pay Scale—If you want to pay your child more than minimum wage, you’ll need documentation supporting the wage. One way to do this is to determine how much it would cost if you hired someone outside the family, and adjust for variables such as skill level and whether it takes your child longer to complete the task than it might take someone else. However, if you’re just paying minimum wage, there’s no need to document your reasoning.
  • Always Use Payroll Checks—Checks maintain a clear trail from your business account to your kid’s checking or savings account. There’s no question left about the amount paid or whether it was paid by the business. When you hire your child, the money you pay is theirs, and you must be able to show that the pay went to a separate account, not one of your own. Also, be sure to check the payment if you use a payroll service; they may mistakenly take out Medicare and FICA, which is unnecessary for a minor.
  • Fill Out Payroll Forms (Both State and Federal)—These are the documents you have to fill out to set up your child as an official employee of your business and properly prove the child’s earnings and any taxes due. The federal forms include IRS Form W-4, IRS Form W-2, IRS Form 941, and IRS Form 940. Even though your minor is exempt from withholding for FICA, Medicare, and unemployment taxes, you’ll still need to turn in those forms. You can find all the forms at the IRS Forms and Instructions page.

Now that you’ve learned all the advantages of hiring your child as an employee for your proprietorship or partnership, it’s time to teach your child the value of money. You’re giving your kid a wonderful opportunity to begin investing early. As mentioned above, your kid can even save up for college with an IRA, which stretches the tax savings even further.

  1. IRC Section 3121(b)(3)(A); Reg. Section 31.3121(b)(3)-1. ↑
  2. IRC Section 3306(c)(5). ↑
  3. IRC Section 1(g). ↑
  4. Eller v Commr., 77 TC 934; Acq. 1984-2 CB 1. ↑
  5. AOD 1985-004. ↑
  6. Gerald W. Jordan v Commr., T.C. Memo. 1991-50. ↑
  7. Denman v Commr., 48 T.C. 439, 450 (196). ↑
  8. Rev. Rul. 73-393. ↑
  9. http://www.dol.gov/elaws/esa/flsa/cl/exemptions.asp ↑
  10. http://www.dol.gov/elaws/esa/flsa/docs/haznonag.asp ↑
  11. Vernon E. Martens v Commr., No. 90-3104, May 91 (4th Cir.). ↑
Categories : Business Expenses, Employ Your Kids, Employees, Payroll, Tax Planning

Tax Topics