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In 2006, you can pay your child up to $5,150 without either of you incurring a tax liability. That’s because reasonable wages you pay to your minor child to work are fully deductible as a legitimate business expense, lowering your gross income. For your son or daughter, the standard deduction eliminates all of the tax on the child’s income. And since the money was earned, the “kiddie tax” doesn’t apply even if your child is under age 18.
Here is an example of how much you can save. Suppose you’re in the 35 percent tax bracket and you pay your 15-year-old daughter $5,000 over the course of a year to perform office-related tasks. Assuming that the $5,000 would have otherwise been part of your business earnings, and taxed at 35 percent, you save $1,750 (35% of $5,000). Since your daughter’s earnings are within the standard deduction, the wages she earns are protected from income taxes.
Even if the child were to earn more than his or her standard deduction, it could still pay off. Since the child is most likely in a lower tax bracket, the earnings would be taxed at 10% or 15% rather than 35%. So, in effect, you’ve converted high-taxed income (yours) into tax-free or lower-taxed income (your child’s).
If your business is unincorporated, hiring your children who work in your business can reduce payroll taxes as well. Under current law, wages paid to a child under age 18 are not subject to FICA taxes (Social Security and Medicare taxes). In addition, wages paid to a child under 21 are exempt from Federal Unemployment taxes. Both the FICA and FUTA tax exemptions also apply if the child is employed by a partnership in which each partner is a parent of the child.
To properly qualify for the deduction, there are requirements you must meet. First and foremost, the work that your children perform must be necessary for the business, and the wages you pay them must be reasonable for the type of work performed. For example, paying your 11-year-old $30 an hour to file papers in your office during the summer months is not likely to pass the scrutiny of the IRS. There’s no age limit for employing your child, but it may be difficult to justify wages paid to a five-year-old.
Treat your children the same as you would any other employee, and be sure you keep good records.
Have your child punch a time clock or write his or her hours down on a timesheet.
You should pay your child by check at the same intervals that you pay other employees. At the end of the year, issue a W-2 form to each of your children who worked in the business and send a copy to the IRS.
When employing your children, one factor you should keep in mind is that money held in your child’s name may reduce the amount of financial aid available. That’s because under the financial aid formula used to determine federal aid eligibility at every college and university, students are expected to contribute between 20 percent and 25 percent of their assets, while parental contributions are capped at 5.6
Everyone’s financial situation is different. A CPA can help you identify the right course of action for your business and your family.