Problem: Combined income and payroll tax can devour half the profit of a self-employed individual. It may be possible to shift income to a dependent child who will pay tax at a lower rate, or no tax.
- Wages are exempt from FICA for a child under 18 employed in a parent’s unincorporated business (sole proprietorship), a partnership in which each partner is a parent of the child or a single-member LLC (SMLLC). [IRC Sec. 3121(b)(3); Reg.31.3121(b)(3)-1(c) and (d)].
- A dependent’s standard deduction ($6,300 maximum in 2016), can be used to shelter up to $350 of the child’s unearned income plus the child’s earned income up to the $6,300 limit.
- A child may qualify to contribute up to $5,500 to a traditional or Roth IRA for 2016.[IRC Sec.219(b)].
- Wages paid by a parent to a child are deductible by the parent’s business if the work is done by the child in connection with the parent’s trade or business.
Solution: An employer-parent can shield self-employment (SE) income from taxation by hiring his child. In addition, this could help reduce or avoid the 0.9% additional Medicare tax for the employer-parent.
Note: Wages paid to a child must be reasonable in relation to the services rendered [IRC Sec. 162(a)]. The business owner should keep detailed records of the child’s employment, including payroll records, in case federal or state taxing authorities or labor departments seek verification. See information about child labor laws under Fair Labor Standards Act.
Example: Marshall is a self-employed rocket scientist, operating as a sole proprietor. His marginal federal tax rate is 28% and his state tax rate is 8%. Marshall has a 16-year-old son named Junior.
Marshall hires Junior as a ray gun tester at the current market rate of $24 per hour. Junior works 40 hours per week through the summer, earning total wages of $11,520 for the year.
Marshall may deduct $11,520 as wage expense from his business income. The wages are exempt from FICA, and Junior pays $0 income tax. Junior’s Form 1040 for tax year 2016 reports the following:
Total Tax ————————————–0
Ignoring for simplicity the SE and state tax deductions, Marshall would have paid $5,776 in total tax on the $11,520 of income at his rate [SE tax $1,628 ($11,520 * 92.35% *15.3%) + federal income tax $3,226 ($11,520 *28%) + state income tax $922 ($11,520 * 8%)].
Note: It may be possible to increase the retirement plan deduction by contributing to an employer’s savings incentive match plan for employees (SIMPLE IRA).
(Reference from Small Business Quickfinder Handbook . There are many other factors that should be considered before using the idea).