By Gary A. Hensley, MBA, EA
If you are operating your business as a sole proprietor (filing Schedule C) then you have a great opportunity to reduce your federal income tax and self-employment tax. In most states you will also reduce your state income tax.
As a sole proprietor you include Schedule C with your federal Form 1040. The Schedule C reports the income and expenses of your business. The net profits from the Schedule C are included in your gross income (on page 1 of your Form 1040) and in your self-employment income on Schedule SE which is also part of your Form 1040. The income tax is assessed based on your marginal tax rate and your self-employment tax is assessed at a rate of 15.3% on the first $118,500 in 2015 and at 2.9% on the amount above $118,500.
The law allows sole proprietors to hire their children as employees
For those children who have not reached age 18, the law does not require the 7.65% withholding and the employer-matching 7.65% of Social Security and Medicare Tax. As a result, this is a direct 15.3% family tax savings. The child must provide a legitimate function necessary to operate the business. In my opinion, it’s a good idea to write out a list of the child’s duties (responsibilities) and record the days and hours he or she works. The child must be issued a W-2 form which will report his or her federal wages for the year. Nowadays, these children are skilled in using computers and analyzing the use of software programs and time-saving skills through the use of data entry, filing, etc.
In 2015, each taxpayer (including your child) has a standard deduction amount of $6,300. Don’t confuse their standard deduction with their dependent exemption which you will still get on your return for providing over 50% of their support.
If your child is under age 18 and you pay your child $6,300 for the year, your business income will drop by this amount. If you, as the parent, are in the 25% federal income tax bracket, this will save you $1,575 (25% X $6,300) in federal income tax and further saves you $963.90 (15.3% X $6,300) in self-employment tax. This is a total tax savings of $2,538.90 per child. [Note: When your child files his or own return (and does not claim a personal exemption since they are your dependent), their wages of $6,300 will be totally offset by their $6,300 standard deduction, leaving them with no federal tax liability on their wages.]
If your child is 18 or older, you will still be allowed to deduct his or her wages of $6,300 on your Schedule C plus your half of the Social Security and Medicare Tax employer match (7.65% = $481.95). You will need to withhold the employee 7.65% portion from your child’s paychecks.
Contact your tax professional for specific advice related to your personal situation and IRS payroll filing requirement rules.
Gary A. Hensley is a member of the National Association of Enrolled Agents (NAEA) and can be followed on Twitter @GaryAHensley.