Whenever I visit a client’s office or family business, I often see young children coloring in the waiting room or solemnly asking when they might be allowed to go home. It is at these moments that I can’t help but to think of their future and the future of family businesses. I often wonder about how work environments might affect them later on, and how, as businesses, we can benefit them. Small businesses often have a very rich family tradition and, on some occasions, there are multiple generations working cohesively. If prepped with an understanding of the tax code, this tradition can transform into a tax planning strategy. One technique that can be used to reduce sole proprietor income is employing your children. Some might argue having a family dynamic within a business can be unproductive; however, there are several benefits to employing your children. Benefits that many find outweigh any potential family disagreements.
Sole proprietors have an advantage over other businesses. They have the ability to higher their children under the age of 18 and defer income to those children without incurring Medicare and social security tax. Taking advantage of this tax savings loophole is perfect for the family-oriented employer who has odd jobs such as filing, cleaning, and mowing.
Take for example, Parent Co, a sole proprietorship. They have a need for weekly office clerical work with an estimated value of $10,000 per year. If Parent Co hires 17-year-old daughter Katy, $10,000 of their taxable income is moved to Katy’s tax bracket. However, not only is the taxable income reduced, but under a special provision for children underage, their social security taxes are also reduced. We have seen instances where the parents have saved more than 30% of income and self-employment taxes by employing their children.
Tax savings can be a great benefit when employing your children but may be scrutinized by the Internal Revenue Service (IRS), so it is important to remember a few things before making any decisions. Keep in mind that the IRS requires the child’s wages to be reasonable. Children should be paid a wage similar to another employee who performs the same type of service. Additionally, the child’s gross income will determine whether or not he/she has any tax liabilities at the end of each year.
There is no doubt the numbers make sense. Employing your children has tax benefits, but often the benefits stretch far beyond the numbers. With earned income comes filing a tax return and opening doors to an endless supply of learning opportunities. Depending on their wages they are also eligible to fund an Individual Retirement Account (IRA). Additionally, they are learning how to earn and budget their own money. This can create a strong lifelong work ethic and a clear understanding that a money tree might not be growing in the backyard after all.
It is important to recognize that there are several factors that could impact these situations. For this reason, it is important to consult your own tax advisor or reach out to a member of the One River CPA Team. We welcome phone calls at: 207-873-1603 or visits at one of our offices located at: 259 Front Street, Bath or 46 First Park Drive, Oakland.