HIRE YOUR KIDS, CUT YOUR TAXES

Paying your kids to work for you in your unincorporated business can boost your wealth by lowering what you owe in taxes.

Believe it or not, your children can provide an incredible opportunity to increase your family wealth by decreasing your tax liability.

The keys to success in this tax game are: Your business is not incorporated, you hire your children to work for you in your business and you pay them reasonable wages. If you do those three things, you can deduct their wages from your income and shift the money to your children who will be in much-lower tax brackets. If you are incorporated, there are still ways to hire your children and to enjoy the tax benefits of doing so — read, at this web site, A Roth IRA for your kids? Yes, you can!

Here’s how my three-step hiring process works:

Hire your children to work for your unincorporated business. If they are under age 18, you will have to pay no Social Security or Medicare tax, and normally no state unemployment or disability taxes, either. The courts already have ruled that you can deduct taxes for any “reasonable wages” that you pay your children ages 7 or older to perform duties related to your work. Your children can work for your primary business or a secondary business that you start. The key is to get your “business” off the ground and show a “profit objective.” So long as you can establish a profit objective, you don’t have to actually make a profit to claim the deductions. Here, then, is another way to hire your kids to work in your business, even if you are incorporated: spin off an unincorporated business line.

Substantiate the deduction. This means you've got to keep records. Put your children on a time clock, punching in and out or writing it down on a time sheet. Pay the children with a check. They can endorse the check over to you for cash to replace their allowance or accumulate the money for college tuition (or any other expense). They can even deposit it into a trust account you’ve set up for their college education. You can even set up a Roth IRA for each of them, as noted above.

I recommend my clients write to their state Department of Labor asking whether the hiring of their children in their unincorporated business would violate any state child labor laws (it won’t, especially if your business is run out of your house). I am less concerned with the answer the state gives than with the substantiation of business motive and profit objective provided by your letter to the Labor Department and their response to you. Keep copies of the letters.

Provide the children with W-2s at the end of the year. You need to give them a real report of what they were paid and send a copy to Uncle Sam.

Assume I have three children, ages 15, 16 and 17. I hire each one to work for me in my unincorporated business and pay each one $7,750. Because they are all under 18, I pay no Social Security, Medicare or state unemployment/disability taxes. Because of the standard deduction, in 2003, the first $4,750 earned by each child is not taxed. The next $3,000 could be sheltered by setting up IRAs for each child (although at their ages, a nondeductible Roth IRA might be a better long-term investment).

The net result is that I have paid my children a total of $23,250 ($7,750 x 3) that I can deduct and is tax-free to my kids. If I am in the top marginal tax bracket of 35%, I've just saved $8,138 each year in federal taxes alone. When I add state tax and Medicare savings to that, I could save probably as much as $10,000 more per year. (The exact amount of savings depends on how you’ve set up your business for tax purposes.)

Nothing here is a leading edge or in any way questionable. Given that you have appropriate documentation and substantiation for your deduction, the only issue the IRS can raise is the “reasonableness” of the compensation. Keep good records and don’t try to pay a 14-year-old child $50,000 a year to file your papers once a week and it’s an easy win.

Other Advantages

There are other potential benefits. For example, if your family’s joint income is $100,000 or more ($50,000 if you’re single, a head of household or a qualifying widow(er)), you can’t claim either the Hope or Lifetime Learning credits. The Hope Credit is as much as $1,500 on the first $2,000 in qualified tuition payments and the Lifetime Learning Credit is 20% of the first $5,000 in qualified expenses. These are dollar-for-dollar reductions in your tax that are denied because you earned too much.

But all is not lost. If your college-student child is also your employee, you can offset any tax imposed on the child’s income by credits on their own return. For example, if I paid my 17-year-old freshman $20,700, let’s see what happens:

The first $4,750 is sheltered by her standard deduction in 2003. If I don’t claim her as a dependent, she gets her own personal exemption of an additional $3,050 for 2003. Add another $3,000 deduction for an IRA contribution and we have a total of $10,800 in tax-free income. The next $10,000 is taxed at a 10% rate for a potential tax of $1,000. But that $1,000 is sheltered and paid by the Hope tax credit because she used the money I paid her to pay her own college expenses.

The net result: My daughter receives $20,800 in income on which she pays zero tax, and I get a deduction of $20,800. In the 50% bracket (federal, state, Social Security and city tax), I get a deduction of $20,800 and save $10,400 in taxes! Simply by hiring my daughter and paying her, my family wealth has increased by $10,400!

Disadvantages

But there are drawbacks. The income paid belongs to your children. If they choose not to use the money for college, you can’t force them to change their minds. Be sure you know what’s going to happen with the money.

The financial-aid packages offered by colleges will be lower in this scenario. That’s because money in your children’s names reduces aid availability more than it would if you held the dollars yourself. Colleges and government agencies use different formulas for students and parents to determine the percentage of money that can be used for a college education. Personally, I prefer actually to accumulate more family wealth today that I can control than to depend on potential financial aid in the future.

Hiring your children doesn’t increase your chances of being audited and it has the potential to increase family wealth substantially. The fact that your children are actually working and, hopefully, learning job skills and developing their sense of responsibility doesn’t hurt, either.