There are Financial Benefits to Putting Family Members on the Payroll

By Dawn Badorini, MST , published on 06/07/2011 in Business West  and in the June issue of Healthcare News

  It is that time of year again. The kids are out of school, and you wonder what they are going to do all summer to keep themselves busy and away from the social-media frenzy. If you are a business owner, there are many potential financial benefits of hiring your children.

One of the biggest incentives of hiring your children is the potential tax savings. The tax savings will vary depending on the type of entity your business is. If you are the owner of an unincorporated business (Schedule C/Self-Employed) you have the greatest potential tax savings. If your children are under age 18, you will not have to pay FICA (Social Security and Medicare) taxes on their wages. Your children are also not required to have these withheld from their paycheck.

For employers, the Social Security portion of the tax is 6.2%, and the Medicare tax is 1.45%. For your children, the Social Security portion is 4.2% (reduced from 6.2% for 2011 only), and Medicare is 1.45%. Also, wages paid to children under age 21 are exempt from federal unemployment taxes (FUTA). Both the FICA and FUTA tax exemptions also apply if your business is a partnership or LLC as long as the only partners are the parents. This is a huge tax savings because you would have to pay these payroll taxes on any other employee you hired.

This does not mean there are no tax benefits if you are an S-corporation or a C-corporation. No matter what type of entity you are, you will get a business deduction for the wages paid to your children, assuming it is for bona-fide work at a reasonable rate. As a corporation, you also get a deduction for the payroll (FICA/FUTA) taxes paid on their wages. This reduces the amount of overall profit subject to income taxes. Assuming you are in the 33% tax bracket, if you pay wages of $10,000 to your child, this could potentially reduce your tax liability by almost $3,700. The tax liability to your child before possible education credits is $985 ($565 FICA and $420 federal income tax). The tax savings to the family is more than $2,700. If you are self-employed, it also reduces the amount of profit subject to self-employment taxes, further reducing your own overall income-tax liability.

Now let’s look at the tax impact on your children. If the wages paid to your children are equal to or less than the standard deduction ($5,800 in 2011), they will not owe any income taxes on their earnings. Even if you pay your children more than the standard deduction, there is typically still a tax benefit. Since your children are most likely in a lower tax bracket than you are, you are shifting income from your higher tax bracket to their lower one. In 2011, taxable income up to $8,500 is taxed at only a 10% rate for a single taxpayer. Also, earned income (wages) is not subject to the ‘kiddie tax.’

Another advantage is that older children may be able to offset any taxes owed by education credits of up to $2,500 claimed on their own individual tax return. In many cases, your income is too high to utilize these education credits. In order for the child to claim any of the education credits, the parents may not claim them as a dependent on their tax return. This results in you losing the deduction for their personal exemption ($3,700 in 2011). To demonstrate the benefit, lets assume the child earns $20,000 working during school breaks and maybe on weekends. Their tax would be $1,530.

This represents only the FICA tax on their earnings, since the income tax is fully offset by education credits. The first $5,800 is tax-free, the next $8,500 has a tax of $850 (10%), and the remaining $5,700 is taxed at 15% or $855. If you or your child paid college tuition of $1,705, they can get a tuition credit of the full $1,705 (100% of first $2,000 of tuition and 50% on next $1,000). The parents’ tax savings could be $4,534, which is a $20,000 deduction plus a deduction of $1,530 for employer FICA less the lost dependent deduction of $3,700, or $17,830 at 33% or $5,553, reduced by the employer FICA tax of $1,530 to net to the $4,534 benefit. Compare this to the child’s tax cost of $1,530, and the family unit saves $2,824.

However, assuming the child does have a tax liability, the overall tax savings is typically still greater when the child is able to claim the education credit. Furthermore, beginning in 2013, personal exemptions will once again be subject to phase-out limits based on income. If your income exceeds these limits, you get no tax benefit for claiming their personal exemption.

Something else you should consider is having your children begin to save for their own retirement by investing some of their wages in a Roth IRA. In 2011, they may make a contribution to a Roth IRA of $5,000 or their taxable compensation, whichever is less. This is an excellent long-term tax-savings investment for your child. They will be able to withdraw this account with all its earnings tax-free upon retirement. This could be substantial since it’s most likely 50 or more years from now.

Of course,there are some limitations and other considerations in employing your children. As mentioned above, in order to get the payroll tax savings (FICA, FUTA), your business must be unincorporated (this includes a sole proprietorship, limited-liability company, or partnership if the only partners are the parents).

There are no age limitations for employing your child, but the work performed must be necessary for the business, and the wages paid must be reasonable for the type of work performed. There could be a little more bookkeeping required as you should keep time sheets showing the dates, hours, and services performed. You will also need to file quarterly payroll tax reports and Form W-2 at the end of the year. However, if you have other employees, you are filing these already. Finally, money held in your child’s name may reduce the amount of financial aid available.

Everyone’s situation is different, but this could be a great opportunity for you to teach your child about your business and help them learn new skills, as well as begin to develop a sense of responsibility, limit the amount of time available for non-desired activities, and save taxes as well.

Dawn Badorini, MST is a manager in the Tax Division of Meyers Brothers Kalicka, P.C. in Holyoke; (413) 536-8510.