If your client has chores their children can do in their business, they should consider hiring them. Generally, children will be in a lower tax rate bracket than your client. Thus, income can be shifted from the client’s higher tax rate bracket to the children’s lower tax rate brackets.
Also, if the children are under 18, your client as the employer, does not need to withhold or pay either Social Security tax or Federal unemployment tax on the children’s wages. The tax treatment under the different Federal employment taxes for family members is:
| Income Tax Withholding | Social Security & Medicare | Federal Unemployment | |
| Son or daughter employed by parent | Taxable | Exempt until age 18 | Exempt until age 21 |
There are four tests a person must meet to deduct the pay to children as a business expense. These are:
1. Ordinary and necessary
The salary must be shown that it, like any other business expense, is an ordinary and necessary expense directly connected with the business.
2. Reasonable
The pay must prove to be reasonable at the time the services were contracted. Reasonable pay is the amount that would normally be paid for similar services under similar circumstances.
3. Services provided
It must be proved that services were actually provided. Also, benefits from the services performed must be reasonably expected.
4. Paid or incurred
The compensation must be paid or the expense incurred during the tax year.
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Example: You are in the 28% tax rate bracket and you are subject to self-employment tax. If you have business filing, typing, cleaning, and other chores for which you hire your child, you can deduct your child’s wages against your business income. The total you pay your 16-year-old child in 2014 is $11,200. Your approximate savings would be:
Your tax savings since you can deduct the wages:
Federal tax ($11,200 x 28%) $3,136
Your tax savings $4,850
Your child’s tax assuming no other income:
Taxable income $5,000 Federal tax $503 Social Security tax 0
Your child’s total tax (503)
Total Federal tax savings to the family $4,347
Additionally, your child is eligible to contribute to an individual retirement account (IRA). In the above example, if your child contributes $5,000 to a deductible IRA, your child pays no tax. The total tax savings to your family is $4,850 ($4,347 + 503). Thus, in 2014, your child can earn $11,200 ($6,200 amount of standard deduction plus $5,000 put into an IRA) without paying any Federal income tax.
Alternatively, your child could contribute to a Roth IRA. In this case, your child would pay $503 of Federal tax but all qualified distributions from the Roth IRA would be completely tax-free.
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Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
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