CHILDREN CAN BE EXPENSIVE! The costs of Food, Clothing, Toys, Summer Camps, etc. can be a bit cumbersome to parents and/or guardians! HOWEVER, for business owners, there is a possibility to somewhat mitigate these expenses while still creating future saving options for the child.
If you own your own business, consider hiring your dependent child as an employee in the business. Then, come tax season, the business will receive a tax deduction for the child’s wages and the child is required to report the corresponding income on their individual tax return. But taking into consideration the changes made to the tax code by the 2017 Tax Cuts and Jobs Act and with proper planning, this can lead to an advantageous tax position for your child both now and for years to come.
Although the IRS does not specify a definitive working age, the business owner should implement this tax strategy cautiously and ethically. The child SHOULD be of reasonable working age and must earn a wage suitable to a position that is ordinary and necessary to the operation of said business.
But you may ask, what about the taxable wages to the child? Every taxpayer, including your child, is permitted a Standard Deduction of the greater of:
1.) $1,050, or
2.) His or Her earned income plus $350 up to the actual Standard Deduction allotted for the given taxable year ($12,400 for the 2020 taxable year; $12,550 for the 2021 taxable year)
Thus, in the 2020 taxable year, up to $12,400 of wages paid to a child is completely sheltered from Federal Income Tax.
Because the dependent child has earned income, he/she is eligible to contribute to an IRA of the guardian’s choosing.
Traditional IRAs allow the taxpayer an above the line deduction for contributions made. However, the distributions are subject to ordinary income tax rates once the taxpayer meets the appropriate age and other requirements. On the other hand, if contributions are made to a Roth IRA, the taxpayer does not receive a tax deduction for contributions made, but the contributions grow tax free and are not taxable to the recipient upon withdrawal once certain requirements are met. Given the low taxable income levels for the average child, this is often the ideal tool to allow your child to begin to save for the future. Next, we will consider the implications of contributing to a Roth IRA.
The maximum contribution for both the 2020 taxable year and 2021 taxable year is limited to the lesser of $6,000 or the dependent child’s earned income. It is important to note that withdrawals of Roth IRA basis (i.e. initial contributions) AT ANYTIME, are both penalty and tax free. Thus, if the child needs to access the funds, they can be withdrawn, up to their basis in the Roth IRA, tax free, regardless of what the funds are ultimately used for. If the goal is more long term, once the owner of the account has reached the age of 59 ½ and the Roth IRA account has been in existence for more than 5 years from the day it was created, both the initial contributions AND the investment earnings can be withdrawn penalty and tax free.
In addition to the 59 ½ age limitation, if the dependent child has aspirations of being the next crafty TAX ATTORNEY and the 5 year qualified holding period has been met, both the initial contributions and earnings from the Roth IRA can be used to finance any qualified higher education expenses. Qualified higher education expenses include things like tuition, fees, books, supplies, or equipment required for enrollment in an eligible education institution. Educational institutions can include either colleges as well as qualified vocational training. Only the investment earnings on education distributions would be subject to ordinary income tax rates.
There is also a special carve out pertaining to first time home buyers! If the dependent child wants to use a portion (up to $10,000) of the ROTH IRA earnings to purchase a home, the withdrawal is exempt from both penalty and income tax if the qualified holding period has been met.
It is worth mentioning, the IRS allows owner operators, organized and structured a certain way, an exemption from paying the employer portion of Self Employment Tax as well as withholding the necessary share of “Federal Unemployment Tax” for wages paid to the dependent child under the age of 18 years old (If the dependent child is under 21, the owner operator is only exempt from the withholding the Federal Unemployment Tax). Note* in order to take advantage of this strategy, the business must be structured as either a Single Member LLC or a partnership in which both partners are the partners. Incorporated entities do not qualify!
If you or someone you know can benefit from this tax savings strategy, please consult with your CPA!