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Tax benefits from hiring children to work in the family business

Although the unemployment figures have improved, it can still be difficult in the current job market for some college students and recent graduates to find seasonal or permanent jobs. The family business may be the only place for some kids to find work or to find their first job. As this Practice Alert explains, employing a child may generate tax savings regardless of how the family business is organized.

Income shifting. Regardless of how a business is organized, its owners may be able to turn some of their high-taxed income into tax-free or low-taxed income by employing their children. The work done by the children must be legitimate, and the amount that the enterprise pays them must be reasonable for the wages to be deductible.

RIA illustration A business person in the 33% tax bracket for 2015 hires her 17-year-old son to help with office work full-time during the summer and part-time into the fall. He earns $6,300 during the year (and doesn’t have earnings from other sources). If that $6,300 otherwise would be paid to the parent, she saves $2,079 (33% of $6,300) in income taxes at no tax cost to her son, who can use his $6,300 standard deduction for 2015 to completely shelter his earnings.

Family taxes are cut even if the child’s earnings exceed his or her standard deduction. That’s because the unsheltered earnings will be taxed to the child beginning at a rate of 10%, instead of being taxed at the parent’s higher rate.

Kiddie tax implications. The kiddie tax applies to the child if he or she does not file a joint return for the tax year and (1) hasn’t reached age 18 before the close of the tax year or, (2) his or her earned income doesn’t exceed one-half of his support and the child is age 18 or is a full time student age 19-23. (Code Sec. 1(g)(2)) Thus, employing a child age 18 or a full-time student age 19-23 could cause his or her earned income to exceed more than half of his or her support. This, in turn, could help to avoid the kiddie tax on the child’s unearned income (there is no earned income escape hatch from the kiddie tax for children under age 18).

Even if the kiddie tax applies, it only causes a child’s investment income in excess of $2,100 (for 2015) to be taxed at the parent’s marginal rate. It has no impact, however, on the child’s wages and other earned income, which can be sheltered by the child’s standard deduction.

Retirement plan savings. Additional savings are possible if the child is paid more (or works part-time past the summer), and deposits the extra earnings into a traditional IRA. For 2015, the child can make a tax-deductible contribution of up to $5,500 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child’s age, and the number of hours worked.

RIA observation: Thus, between the child’s standard deduction and IRA contribution, a child can earn up to $11,800 in 2015 without paying any income taxes.

Tax savings via education credits. Additional intra-family tax savings in the form of education credits may be available.

For 2015, taxpayers may claim an American opportunity tax credit (AOTC; formerly known as the Hope credit) equal to 100% of up to $2,000 of qualified higher-education tuition and related expenses plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. Thus, the maximum AOTC is $2,500 a year for each eligible student. (Code Sec. 25A(a)(1), Code Sec. 25A(i)(1)) For 2015, the availability of the credit phases out ratably for taxpayers with modified AGI of $80,000 to $90,000 ($160,000 to $180,000 for joint filers).

The AOTC may be elected for a student’s expenses for four tax years, and only for students who have not completed the first four years of post-secondary education as of the beginning of the tax year. (Code Sec. 25A(b)(2), Code Sec. 25A(i)(2))

Subject to an exception, 40% of a taxpayer’s otherwise allowable AOTC is refundable. No portion of the credit is refundable if the taxpayer claiming the credit is a child subject to the kiddie tax under Code Sec. 1(g) (Code Sec. 25A(i)(5)) or a resident of a U.S. possession (who instead claims the credit where he resides). (Conf Rept No. 111-16 (PL 111-5) p. 13)

Taxpayers may elect a Lifetime Learning credit equal to 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit for any taxpayer for a tax year is $2,000, regardless of the number of students for whom he has paid qualified amounts. (Code Sec. 25A(a)(2), Code Sec. 25A(c)(1)) For 2015, the credit is phased out ratably for taxpayers with modified AGI from $55,000 to $65,000 ($110,000 to $130,000 for marrieds filing jointly).

Where a parent pays the college education expenses of a child whom he claims as a dependent, only the parent may claim the education credits (if otherwise eligible). However, if a parent is eligible to but does not claim a student as a dependent, the student may claim the education credit for qualified expenses paid by him or the parent. (Reg. § 1.25A-1(f)(2), Example 2, IRS Pub. 970 (2014), p. 18, p. 27)

RIA recommendation: It may pay for a parent not to claim the student as a dependent if (1) the parent can’t claim education credits because of high modified AGI, and (2) the student pays, or is deemed to pay under Reg. § 1.25A-1(f)(2), Example 2 the expense, and has sufficient tax liability (e.g., from summer or part-time employment) to claim the credit.
RIA illustration: A married couple has AGI of $250,000 and is in the 33% bracket. For 2015, claiming their 19-year-old college-freshman son as a dependent would save $1,320 in taxes (33% of $4,000 dependency exemption for the son). The parents spend $24,000 on the son’s AOTC-eligible qualified tuition. The son has $15,000 of taxable income from his salary working for the family business and has no other earned income. The parents can’t claim an education credit for their child because of their high income and would be better off not claiming their son as a dependent. If they don’t claim the son as a dependent, the son may use the education credit to completely eliminate his $1,788.75 tax liability (10% of $9,225 taxable income, plus 15% of the $5,775 balance). However, note that under Code Sec. 25A(i)(5), the son would not be able to claim a refundable AOTC because he is subject to the kiddie tax under Code Sec. 1(g) (he is a full time student age 19-23 and his earned income doesn’t exceed one-half of his support).
RIA caution: If a parent is eligible to claim a child as a dependent but doesn’t, the child still cannot claim an exemption for himself.
RIA observation: The case for not claiming the child as a dependent would be even more compelling if the parent’s personal exemptions would be reduced by the personal exemption phaseout (PEP). For 2015, for example, the exemption phaseout for joint filers and surviving spouses begins at $309,900 of AGI and ends at $434,400 of AGI.

Income tax withholding. Regardless of how the family business is organized, it probably will have to withhold federal income taxes on the child’s wages. Usually, an employee who had no federal income tax liability for the prior year, and expects to have none for the current year, can claim exempt status. However, exemption from withholding can’t be claimed if (1) the employee’s income exceeds $1,050 and includes more than $350 of unearned income (such as dividends), and (2) the employee may be claimed as a dependent on someone else’s return (whether or not he actually is claimed). (Instructions to Form W-4 for 2015) Keep in mind that the child probably will get a refund for part or all of the withheld tax when he or she files a return for the year.

FICA and FUTA. Employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. (Code Sec. 3121(b)(3)(A)) This can generate some savings for a parent who runs an unincorporated business, including an entity disregarded as separate from its owner for tax purposes. (Reg. § 31.3121(b)(3)-1T)

RIA illustration: A sole proprietor who usually takes $120,000 of earnings from the business pays $5,000 to her 17-year-old child in 2015. The sole proprietor’s self-employment income would be reduced by $5,000, saving her $145 (i.e., the 2.9% HI portion of the self-employment tax she would have paid on the $5,000 shifted to her child). (However, this savings doesn’t take into account a sole proprietor’s income tax deduction for one-half of her own social security taxes.) That’s on top of the $382.50 (.0765 × $5,000) in employee FICA that the child saves by working for a parent instead of someone else.

A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents.

However, there is no FICA or FUTA exemption for employing a child in an incorporated business or in a partnership that includes non-parent partners. The children are subject to the same rules that apply to all other employees.

RIA observation: For an updated Client Letter on this subject, see FTC Client Letters ¶  2375.1.
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