"Putting your youngster on your payroll can be a savvy way to take care of his or her allowance at the expense of the Internal Revenue Service.

"Significant tax savings can result merely by moving the money from one family pocket to another."

- Julian Block in Homemade Money: Bringing in the Bucks.

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.

Block's several books include:

Tax Tips For Small Businesses

Year-Round Tax Savings

Marriage And Divorce

The Home Seller's Guide to Tax Savings

Travel And Moving Expenses

For more information, visit Julian's website.

 

 

 

 

 

 

 

Profit from Paying Your Kids

Special Tax Tips for
Homebased Entrepreneurs
for the Current Year

by Julian Block
 

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 business. This holds true, whether it is a full-time, long-established operation or just a new, part-time sideline.

Going that route isn’t 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 isn’t 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. Recently revised rules further curtail opportunities for families to shelter investment income.

Although the point is often overlooked, the onerous kiddie tax restrictions aren’t applicable to children's wages, whether those earnings are derived from babysitting, delivering newspapers, or even working for a parent-owned business. 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’s much greater. So the more income the child receives as earnings, the more that escapes taxes because of the standard deduction.

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. Nadine can use her earnings to support herself or put away for college, a wedding, a car, or a post-graduation vacation. She sidesteps taxes on her wages to the extent of her standard deduction.

True, earnings in excess of the standard deduction will lead to a tax liability for Nadine. However, the excess typically falls into the bottom income-tax brackets of 10 percent and 15 percent.

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 (6.2 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 15.3 percent.

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. To be eligible for a Roth, she must have earned income. But the source of that Roth contribution 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 usually 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 the Child Tax Credit

Legislation enacted in 2004 overhauled the rules that allow parents to claim exemptions for their children. The revised rules 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 revised 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 can’t 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 don’t count as spent by her for her support.

There is yet another tax trap: No exemptions for Nadine or yourself if you're subject to 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. Under current law, the credit is $1,000 for each child. Restrictions on who qualifies for the credit disqualify upper-income individuals.

The child tax 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.

The distinction is critical. 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.

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’re 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 can’t be more than the going rate for unrelated employees who perform comparable tasks. That doesn’t 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 weren’t 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 are a number of ways to fall afoul of the IRS. In one case, the 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 didn’t 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’s 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 allowed. "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.

The key to winning these kinds of disputes: 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.

_______________________

Julian Block, an attorney in Larchmont, N.Y., 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).

© 2013 by Julian Block. All Rights Reserved. This article is excerpted from his book, Easy Tax Guide for Writers, Photographers and Other Freelancers, praised by law professor James Edward Maule of Villanova University as "An easy-to-read and well-organized explanation of the tax rules. Writers, photographers and artists would be well advised to buy this book.”

The 2013 edition is now available in Kindle format. Print copies of Julian's books are available at JulianBlockTaxExpert.com.

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