|
|
Barbara's Books |
Brabec Bulletin |
Contact |
|||
|
Julian Block is a syndicated columnist, attorney, and former IRS investigator who has been cited by the New York Times as "a leading tax professional," and by the Wall Street Journal as an "accomplished writer on taxes." Block is well known for his ability to translate complicated tax laws into plain English and for the concise, entertaining way he alerts readers of his nationally syndicated column, The Tax Adviser, to simple, perfectly legal, tax-saving strategies. Block's several books include: 
Tax Tips For Small Businesses
For more information, visit Julian's website. NOTE: Julian Block has been Barbara's tax expert through the years, generously contributing his time and talent in checking the tax information in her books, particularly in all editions of Homemade Money since first published in 1984.
Other Helpful Tax Resources Internet Tax Guide, 2007 edition. If you sell products, services, subscriptions or advertising on your website, you need the tax information in this new guide from Sandra K. Brooks, CPA. (Purchase includes free quarterly updates.) CPA Joni M. Becker offers My Tax Tutor for Home Business Owners, and other guides for small business owners and Internet marketers. Worth investigating if you're serious about saving money on your taxes every year. Wayne M. Davies, who has been helping small business owners "beat the taxman" for the past fifteen years, is the author of The Small Business Tax Reduction Toolkit. It explains how any small business owner or self-employed individual can save thousands in taxes. When you visit this site, you can also sign up for the author's free online newsletter and get a special report by email titled, "How To Instantly Double Your Deductions."
U.S. NEWS & WORLD REPORT: Since minors can't vote, is it legal to tax their income? That
question of "taxation without representation" was posed to the Treasury Department by a
taxpayer. Treasury's written reply: "Congress represents all
Americans, including those who cannot or do not vote." "Using your child as a tax shelter may sound Dickensian, but
there is nothing wrong or illegal about it."
|
Updated for tax year 2007!Profit from Paying Your Kids
Special Tax Tips for
|
|
|
by
Julian Block,
Tax Tips for Small Businesses |
Can your children help out with some of the chores connected with your business? Then a savvy way to take care of their allowances or spending money—at the expense of the Internal Revenue Service—is to pay them wages for work they do on behalf of the business. This holds true, whether it is a full-time, long-established operation or just a new, part-time sideline.
Going that route is not just a strategy to save taxes for the family as a unit. It also provides
your children with jobs that put some “jingle in their jeans,” familiarizes
them with the business, and instills a bit of the old work ethic. Here are
several strategies to keep in mind when your business pays them compensation
that it deducts and they report on their returns.
Staying
Clear of "Kiddie Taxes"
Putting your children on the payroll is a
perfectly legal way to keep income in the family, while shifting some out of
your higher bracket and into their lower bracket. This maneuver is not crimped
by complicated "kiddie tax" rules that drastically restrict the ability of
parents and grandparents to shift investment income from themselves to their
lower-bracket children and grandchildren by gifts of cash, stocks, mutual fund
shares, real estate, money and other income-generating assets. Starting in 2008,
revised rules further curtail opportunities for families to shelter investment
income. Although the point is often overlooked, the onerous kiddie tax restrictions
are not applicable to children's wages, whether those earnings are derived from
babysitting, delivering newspapers, or even working for a business owned by a
parent. The business gets to deduct the wages, which are taxed to the child at
the child’s own rate. Consequently, it might prove more advantageous to pay
wages to a child than to bestow properties on him or her that generate an
identical amount in income. As is true of investment income, the child gets to offset earned income with
a standard deduction, but one that is more than six times greater. Whereas
2007’s flat amount standard deduction is capped at just $850 for investment
income, it tops out at $5,350 for wages and other kinds of earned income. So the
more income the child receives as earnings, the more that escapes taxes because
of the standard deduction, which also is indexed.
The Way It Works
Whatever the child’s age, however, this arrangement can work very neatly. Imagine that your business hires Nadine, your 16-year-old daughter, to do clerical work after school, on weekends and during school vacations. For 2007, Nadine earns $5,350, which she can use to support herself or put away for college, a wedding, a car, or a post-graduation vacation. She sidesteps taxes on her entire wages as they are sheltered by a standard deduction of $5,350.
True, earnings above $5,350 will lead to a tax liability for Nadine. However, the excess falls into the bottom income-tax bracket of 10 percent, which applies to taxable income of up to $7,825. Her 15 percent bracket applies to taxable income between $7,825 and $31,850. In fact, using 2007 as a marker, not until taxable income surpasses $31,850 would this part-time teenage employee move beyond the 15-percent bracket and ascend to the relatively lofty 25-percent bracket.
Assuming you fall into a 35 percent federal and state bracket, hiring her lowers your taxes by slightly more than $1,872 (35 percent of $5,350). Of course, the exact amount will depend on whether Nadine’s wages are subject to Social Security and other payroll taxes.
CAUTION:
Unsurprisingly, the IRS bars any deductions for the value of meals and lodgings furnished by you. That is not considered part of Nadine’s compensation. As a parent, you are legally obligated to support her.Social Security Taxes
Generally, the wages you pay Nadine and other employees are subject to Social Security (6.20 percent) and Medicare taxes (1.45 percent) that aggregate 15.30 percent (7.65 percent for both employer and employee). But Internal Revenue Code Section 3121(b)(3)(A) authorizes an exemption from these taxes for wages you pay to your under-age-18 sons or daughters. The exemption applies when you do business as (1) a sole proprietorship (IRS lingo for the lone owner of a full-time or part-time business that is not formed as a corporation or a partnership with a partner other than your spouse) or (2) a husband-and-wife partnership. Consequently, whatever income you are able to shift to your children lowers your Social Security taxes by as much as 15.30 percent. In 2007, this rate applies just to the first $97,500 of net self-employment earnings (receipts minus expenses); the rate is 2.90 percent on net earnings above $97,500.
Roth Individual Retirement Accounts
Another break for Nadine is that each year she has the option to put part of her wages into a Roth IRA — as much as $4,000 for 2007.To be eligible for a Roth, she must have earned income. But the source of that $4,000 need not be her wages. It can be a gift from, say, you or her grandparents.
Sure, she gets no deductions for her Roth contributions; but the write-offs would be worth little or nothing anyway because her brackets are low — 15 or 10 percent — or even zero. The big benefit is that those Roth contributions will grow without being taxed. Nadine can withdraw contributions at any time if she needs to tap the account. As for the earnings, there are restrictions. Generally, she will be able to withdraw earnings free of taxes only after she attains age 59 1/2, by which time they will have swelled enormously.
Dependency Exemptions and Child Tax Credit
Legislation enacted in 2004 overhauled the rules that allow parents to claim exemptions for their children. The revised rules took effect at the start of 2005 and impose several requirements for claiming under-age-19 children like Nadine. The new rules are unlikely to disqualify you from claiming Nadine, regardless of how much she receives as reportable income, whether wages from you or income from other sources.
Under the new rules, the key requirement is that Nadine must have the "same principal place of abode" — IRS lingo for residence — as you do for more than half of the year in question. The IRS disregards temporary absences by Nadine attributable to vacations, sickness and the like.
Another requirement is that Nadine cannot provide more than half of her support for the year. But the IRS counts only what Nadine actually spends for her support, not the entire money available for that purpose. For instance, wages that Nadine moves into Roth IRAs or simply saves do not count as spent by her for her support.
The exemption amount is $3,400 for 2007, up from $3,300 for 2006. An exemption of $3,400 lowers taxes by slightly more than $1,000 if you are in a 30 percent federal and state bracket.
Exemptions start to phase out, that is, gradually disappear, when AGI, short for adjusted gross income, surpasses certain levels that are indexed. The disallowance affects all exemptions that can be claimed on a return, including those for a spouse and dependents like Nadine.
Exemptions begin the phasing out process when AGI exceeds designated amounts. For 2007, they are: $156,400 (up from $150,500 for 2006) for singles; $234,600 (up from $225,750) for joint filers; $195,500 (up from $188,150) for heads of household; and $117,300 (up from $112,875) for married persons filing separately. They vanish when AGI is greater than: $278,900, $357,100, $318,000 and $178,550 for singles, joint filers, heads of household and married persons filing separately, respectively.
The phasing out of exemptions is itself gradually phased out, unless the law changes. On returns for 2006 and 2007, the required disallowance of exemptions is 2 percent of the amount by which AGI exceeds the specified amount, dropping to 1 percent for 2008 and 2009. After 2009, the phase out ends.Another complication began in 2006.
There is yet another tax trap. No exemptions for Nadine or yourself if you are subject to the AMT, alternative minimum tax.
Claiming an exemption for Nadine or another child under the age of 17 qualifies you for the child tax credit, provided you satisfy its eligibility requirements. For 2007, the credit is $1,000 for each child, unchanged from 2006.
Restrictions on who qualifies for the credit disqualify upper-income individuals. The credit begins to phase out, that is, gets reduced when modified AGI (the same as AGI for most individuals) exceeds $110,000 on a joint return, $75,000 on a single return, and $55,000 for married individuals filing separate returns.
The child credit and other credits are subtracted from the tax itself, resulting in dollar-for-dollar reductions of the tax that a person would otherwise owe; write-offs for exemptions and other deductions merely result in reductions of the amount of income on which to figure taxes.
Whereas a deduction of $1,000 is worth only $250 for someone in a 25-percent bracket, dropping to just $100 for someone in a 10-percent bracket, a credit of $1,000 reduces a person’s tax tab by $1,000, whatever the bracket happens to be.The distinction is critical.
Withstanding Audits
No matter how closely you follow the rules, IRS auditors are understandably suspicious of deductions for wages paid to your own children. The write-offs survive scrutiny only if you are able to establish that the children actually render services. Expect the feds to throw out a deduction for hiring, say, a six-year old to do photocopies; someone that age likely lacks the skills or discipline for office work.
Another hurdle is the "reasonableness" requirement. Wages paid to children cannot be more than the going rate for unrelated employees who perform comparable tasks. That does not mean you have to be a parsimonious paymaster who doles out only the minimum wage. But it does mean that you have to treat your children the same as any other employee and keep the usual records showing amounts paid and hours worked. Give them W-2 forms, even if they qualify to exempt their wages from withholding for income taxes; use checks drawn on business accounts to evidence the payments. Otherwise, the IRS might contend that the payments exceeded the going rate or that your youngsters were not bona fide employees; they merely rendered the token kinds of services that parents expect their children to perform.
TIP: Responsible students are able to handle all kinds of chores. Some of the more common ones include answering telephone calls, cleaning offices, addressing envelopes, filing, bookkeeping, secretarial and other clerical work and making deliveries. Nowadays, lots of kids are more adept with computers than older employees.
What Will Trip You Up
Unfortunately, there a number of ways to fall afoul of the IRS. In one case, the United States Tax Court threw out deductions for payments over a two-year period by an Indiana surveyor to his children, ages nine and eleven, for sweeping out his office and helping him with surveys. For one thing, he kept no records of the time they worked. And his case really went down the drain when the judge examined the children's pay checks and found all of them had been redeposited in the father's account.
In another case, the Tax Court concluded that the "salary" at issue, which had been turned over by Dr. Anthony R. Furmanski, an Encino, California, neurologist, to his teen-age daughter, was merely an allowance, and not, as he claimed, wages paid for secretarial services at his office, and for regularly answering calls from patients at his home when the answering service was off and he did not want to be disturbed. Among other things, a dubious judge noted that children normally answer the family phone. Nor was the doctor’s case helped by his admission that he made the entire payment to his daughter in advance — and paid nothing to his son for answering calls. The clincher was his failure to keep any records showing when she worked for him at the office or at home, or, in this particular situation, to withhold taxes on the payment.
Then there is the frequently cited case of Walter and Dorothy Eller, who hired their three children, ages 7, 11, and 12, to work at their mobile home parks in California. During a three-year period spanning 1972-1974, the kids did the following: cleaned the grounds and laundry room, performed landscape work, maintained the swimming pool, read gas meters, answered phones, delivered leaflets and messages, and made minor repairs. The Ellers deducted nearly $18,000 of their payments to the children as "outside services," of which the IRS disallowed about 90 percent as unreasonable.
But the Tax Court concluded that, had the children not done the work, the Ellers would have had to hire someone else to do it. As the children performed "substantial services," the court approved more than $15,000 as allowable.
Most of the disallowance was attributable to the 7-year old, although around $4,000 of his earnings were okayed. "Experience teaches that 11- and 12-year old children can generally handle greater responsibility and perform greater services than seven-year-old children," the judge explained.
Truly treat the children like employees; be able to document that the children actually perform the chores for which they are paid, make sure that the work is necessary for the business, and pay only reasonable amounts for the jobs performed.The key to winning these kinds of disputes:
_______________________
© 2007 by Julian Block. All Rights Reserved
Julian Block, an attorney in Larchmont, NY, has been cited as a "leading tax professional" (New York Times), "an accomplished writer on taxes" (Wall Street Journal) and "an authority on tax planning" (Financial Planning Magazine). He conducts continuing education courses for tax professionals. This article is excerpted from Tax Tips For Small Businesses: Savvy Ways To Trim Taxes To The Legal Minimum, praised by law professor James Edward Maule of Villanova University as "An easy-to-read and well-organized explanation of the tax rules. Business owners would be well advised to buy this book." It explains strategies to reduce taxes for this year and even gain a head start for future years. An order form for his books is at JulianBlockTaxExpert.com