The Tax Cuts and Jobs Act of 2017 (TCJA) changed many areas of the tax code, including when family business hires their child(ren). While there was a similar pre-TCJA benefit to hiring one’s child(ren), the new law increased several tax savings and warrants another look at hiring children into the family business.
The largest benefit of hiring a child into a family-owned business is the ability to convert the parents’ high-taxed income into tax-free or low-taxed income. There are rules that must be followed; specifically, the children’s work must be legitimate, and the amount the enterprise pays them must be reasonable for the wages to be deductible.
With TCJA roughly doubling the standard deduction, the amount of income taxed at 0%, federally, has increased to $12,200 for individual filers in 2019; however, state income taxes may apply. Typically, if a child is at a lower federal rate than their parents, they will also be at an equal or lower state income tax rate. Family taxes are reduced even if the child's earnings exceed their standard deduction, because the unsheltered earnings are taxed to the child beginning at a rate of 10%, instead of at the parent's higher rate.
A business owner in the 35% tax bracket for 2019 hires their teen child to help with office work full-time during the summer and part-time throughout the year. The teen earns $12,200 during the year (and has no earnings from other sources). If that $12,200 were paid to the parent, they would incur a federal tax liability of $4,270 (35% of $12,200). Instead, by paying the wages to the teen, the parent(s) reduces their family tax burden by $4,270, since the teen pays no tax because the standard deduction of $12,200 shelters their earnings. The tax savings can add up when the business owner has multiple children to employ.
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 2019, the child can make a tax-deductible contribution of up to $6,000 to their IRA. The business may also provide the child with retirement plan benefits, depending on the plan it uses and its terms, the child's age, and the number of hours worked.
As a result, between the standard deduction and IRA contribution, a child could earn up to $18,200 in 2019 and pay no federal income taxes ($12,200 standard deduction + $6,000 IRA contribution).
Alternatively, instead of paying the child an additional $6,000 to contribute to a traditional IRA for a current deduction, a child could contribute up to $6,000 of their $12,200 salary, which is free from federal income taxes, to a Roth IRA and take advantage of tax-free growth when they retire.
The power of compounding tax-free growth could be significant. For example, by contributing the maximum $6,000 to a Roth IRA each year from 16-18 (three years), by the time the child reaches 65 he or she would have accumulated nearly $500,000 of tax-free retirement money, assuming an annual rate of 7%. Though it will take your child many years to reap the benefits of this planning opportunity, they would be wise beyond their years to consider this strategy now.
Alternatively, if your child wants to keep their hard-earned salary, consider making an annual excludable gift on their behalf to a retirement account. Read more about this strategy here.
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. This can generate savings for a parent who runs an unincorporated business, including a single-member LLC.
A sole proprietor who usually earns $120,000 from the business pays $12,200 to their 17-year-old child in 2019. The sole proprietor's self-employment income would be reduced by $12,200, saving self-employment tax on the amount paid to their child. That's on top of the employee FICA the child saves by working for a parent instead of someone unrelated.
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 their 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. In those instances, children are subject to the same rules that apply to other employees.
As you can see, many opportunities for savings exist when hiring your children. If you are a family-business owner and are looking for ways to lower your tax liabilities, call on us at Drucker & Scaccetti. We’ve been advising family businesses for nearly 30 years and would be happy to help you.