Archive for Payroll

Hire Your Kid and Get a Tax Break

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 IDEven 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 SheetHaving 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 ChecksChecks 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.
  11. Vernon E. Martens v Commr., No. 90-3104, May 91 (4th Cir.).

The Relationship between Your Salary and Your Taxes

It’s no secret that the more money you earn from your S corporation, the higher your tax bracket. But, have you actually run the numbers to see what damage—if any—your current salary is actually doing? If not, it’s time you did. As a business owner, you can’t leave financial matters to chance.

A big, fat salary may look nice, but it could actually be losing you money. By capping your own income at the proper amount, you can save yourself thousands of dollars in taxes. The old adage, “A penny saved, a penny earned” certainly applies when it comes to dealing with tax brackets.

Calculating the Right Number

Some may think the solution is to dramatically reduce your salary, but watch out for that tactic! If you set your salary too low, this can also arouse the suspicion of the IRS and elicit an audit. Did you know that if you set your salary unusually low, you could end up paying not only back taxes, but also penalties and interest? Luckily, this article is your guide to getting the amount right—for the most advantage and least audit risk.

The IRS actually has guidelines to setting reasonable salaries for S corporation owners. Keep in mind these are just guidelines created by the IRS—not tax law—but playing by IRS rules goes a long way towards reducing your chances of audit. The good news for you is that a few recent court cases help taxpayers like you to understand how these guidelines are held up (and how you can justify your salary).

Salary Case Examples

First, let’s look at how reducing your salary lowers your payroll taxes. For a sole proprietor earning $100,000 in business income for the year, $14,130 will be paid in self-employment taxes.[1] However, if you form an S corporation and give yourself a salary of $50,000, you pay only $7,650 of payroll taxes between yourself and your corporation combined.[2] That’s nearly $6,500 in tax savings! The remaining $50,000 can be considered a distribution, and those are not subject to payroll taxes.[3]

To see how all this is viewed by the IRS, let’s examine the results of precedent cases:

  • The S Corporation Accountant—David Watson operated his accounting business as an S corporation.[4] His corporation also happened to be a 25 percent partner in an accounting firm. For several years, the firm paid Watson’s corporation more than $200,000. Watson’s self-appointed salary, however, was only $24,000. As you can guess, this is far below the average salary for an accountant.

In fact, the IRS determined that for the area of the country where Watson did business, a reasonable salary was more like $91,044. They came to this conclusion using the Management of Accounting Practice survey conducted by the American Institute of Certified Public Accountants, which listed compensation. For an accountant with no investment interest, average salary was $70,000.

However, Watson did have investment interest. Considering that owners billed at rates 33% higher than directors, the IRS’s valuation expert then increased the reasonable amount by 33% and decreased that amount to reflect fringe benefits that were not taxed—coming up with the $91,044.

In the end, the court sided with the IRS expert and Watson’s salary was adjusted to the more reasonable number. He still took the majority of his income payroll tax-free as distributions (giving him bigger savings than he would have as a sole proprietor), but he got hit with $23,431.23 in payroll taxes owed, penalties, and interest.

  • The Real Estate ProfessionalSean McAlary entered the real estate business before the housing crash.[5] His success allowed him $240,000 in distributions from his S corporation in 2006. The mistake he made was taking absolutely no salary—$0—despite being entitled to $24,000, according to corporate minutes.

Using methods similar to those above, the IRS valuation expert determined a reasonable salary of $100,755. Using the California Occupational Employment Statistics Survey, the expert found real estate brokers’ median wage to be $48.44 per hour. That wage was then multiplied by a 40-hour work week and again by 52 weeks. This was despite evidence that McAlary actually worked longer hours and rarely took days off. The court adjusted this finding slightly, and McAlary’s salary for tax purposes was considered to be $83,200, still making distributions a majority of his income.

  • The Glass Blocks ManufacturerFrederick Blodgett produced glass blocks to be used in homes and other real estate. Unfortunately, the construction industry in his area had a bad year in 2006, and his company felt the fall.[6] So, in the following two years, he ended up loaning his S corporation $55,000. The corporation’s net income for each of the two years was $877 and $8,950.

For 2007 and 2008, Blodgett drew no salary from his corporation. Instead, he took what he described as a mix of distributions and loan repayment, in a total of $30,000 per year. His plan was not viewed his way by the court. The “loans” were deemed capital contributions, making 100 percent of his corporation’s payments to him distributions.

It was decided by the IRS, and held up by the court, that the $30,000 per year distributions would be assigned as Blodgett’s salary. Rather than doing calculations like those in the above cases, the IRS simply stated that someone in Blodgett’s field would make at least that much. The decision gave Blodgett’s business a net loss for the year.

Applying the Lessons

You can see a few tips from these examples. First of all, when setting your salary, consider what other professionals in your field make in your area. Being self-employed, you may not always be able to match yourself to a single profession with compensation statistics. In that case, choose a best match that you can reasonably back up.

Of course, you are also a business owner, so after comparing wages, you’ll need to adjust for several factors. Decrease your wage to account for:

  • Your business’s profit relative to similar businesses in your area (if your profits are smaller);
  • The number of hours you work (if you work less than full-time); and
  • Factors that contribute to your corporation’s success outside of your own personal efforts (for instance, unusually good market conditions for a particular year).

If you’re able to reduce your salary by a reasonable amount because of one of these circumstances, be sure to document your reasoning in the corporate minutes. The lower salary will give you big savings on payroll taxes, as long as it remains reasonable.

As a final note, you do not have to take a salary if your S corporation is not making a profit.[7] Just be prepared by understanding that taking distributions in a year you don’t take a salary is a major red flag to the IRS. If you don’t take a salary in a particular year, try to eliminate or at least minimize the distributions you take.

Reducing your salary is a legal tax strategy for S corporation owners. As long as you don’t take it to the extreme, the technique is an easy way to keep more of your cash. So, research comparable salaries in your area, adjust it downward if you can do so justifiably, and always document your strategy.

  1. Assuming a 15.3 percent self-employment tax rate is applied to 92.35 percent of the income. See Schedule SE for rate details.
  2. $50,000 x 15.3 percent.
  3. Rev. Rul. 59-221.
  4. Watson v US, 668 F.3d 1008 (8th Cir.).
  5. Sean McAlary Ltd, Inc., TC Summary Opinion 2013-62.
  6. Glass Blocks Unlimited, TC Memo 2013-180.
  7. See Davis, d/b/a Mile High Calcium, Inc. v US, 74 AFTR 2d 94-5618.

What the Statute of Limitations Means for Your Tax Records

When you went into business, chances are you weren’t imagining grand evenings filled with paperwork. Maybe you thought tax records were a thing you would think about once a year and have your accountant deal with. But, the truth is, as you progress in business, you come to realize that record-keeping for your taxes needs regular maintenance. In fact, even after you breathe a sigh of relief once that return has been double-checked and sent off to the IRS, you may need to make a change to the document.

That’s where the statute of limitations comes in. It refers to the periods of time during which both you and the IRS may make changes to your tax return (not just audits). Those time frames are clearly delineated in IRS publications[1].

Here they are:

  • No limit if you did not file a return
  • No limit if you filed a fraudulent return
  • Three years after filing if you filed on time (or with extensions), you did not understate your income by 25 percent or greater, and you did not file fraudulently
  • Six years after filing if you filed on time (or with extensions) but you understated your income by greater than 25 percent
  • If you filed an amended return or already made changes to the original return (like a quick refund claim), either three years after filing or two years after paying the tax
  • Seven years from filing for a claim filed for a bad-debt deduction or loss from worthless securities

Keeping Appropriate Records

Aside from letting you know how long you have to make changes to a return, the statute of limitations also lets you know how long the IRS has to audit your return. If an audit occurs, you are going to need all of your tax records to prove your deductions. What does this mean for your record keeping habits? Hang on to those records until any chance of audit has passed.

The following are a few guidelines for making sure you hold on to the appropriate records long enough:

  • Employment Tax Records—If you have employees, you need to save your employment tax records for four years after whichever date comes later, the date payroll taxes were paid or the date they were due. An easy way to do this is simply to keep six separate drawers in your filing cabinet for each tax year. Every year, discard the sixth drawer when it’s statute of limitations expires.
  • Records for AssetsYou have certain assets that are pertinent to your tax return for as long as they remain in the depreciable category. Examples of such assets include your office building, computers, desks, and even your car. If you are depreciating those assets, they will be on your tax return. Otherwise, if you are using Section 179 to expense the assets, you may be able to recapture the depreciable class life.

For example, let’s say you purchased a desk for $1,500 and depreciate it over the seven year Modified Accelerated Cost Recovery System (MACRS) life, which takes eight years. You’ll still have to prove depreciation in the eighth year. So, you need the record of the original purchase in the eighth year and through the eleventh year to meet the three year statute of limitations (the time during which this purchase is subject to auditing). The example works the same if you used Section 179. Any assets with more than a one year class life should be kept in a separate, permanent file so they don’t get tossed out with files whose statutes of limitations have expired.

Record Keeping Tips

As mentioned in the section on employment tax records, you can simplify your file system by devoting separate drawers for each tax year. In those drawers, you’ll put any information on assets, income, and other information applicable to your return. The first drawer will be where you put all documents as you acquire them throughout the year. The next drawer is last year’s tax documents. The drawer after that contains documents from three years ago, and so on until you reach the year at which your statute of limitations expires.

In order to use this method, it’s important that you file your taxes on time or file an extension so you know for sure your specific time frames. At the end of each year, the last drawer gets dumped and you move the other drawers down, starting a new drawer for the current year. It’s really simple once you put the system in place. Record-keeping may seem tedious, but remember, it shows you where your business has been and where it’s going, like a runner trying to improve their time. You can’t improve the numbers if you don’t know what they are.

  1. IRS Pub. 583, Starting a Business and Keeping Records (Rev. December 2011), Dated Feb. 17, 2012, p 12.