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. 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.
Checkmark
AB Tax Accounting 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.
AB Tax
Accounting 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)
AB Tax
Accounting 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.
Checkmark
AB Tax Accounting 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).
AB Tax Accounting
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.
AB Tax
Accounting 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)
AB Tax
Accounting 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.
Please call me if you
have any questions about these rules. Together we can make sure that you'll get
all the deductions to which you're entitled come next filing deadline. I look forward to hearing from you. Click
this link to view our YouTube video http://youtu.be/EYJdQtbPZAI
Amare
Berhie
(651)
621-5777, (952) 583-9108, (612) 224-2476, (763) 269-5396
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