Hiring Children to Work in the Family Business can Generate Tax Savings

When times were better, many college students looking for summer employment and graduates looking for permanent jobs thought of working for the family business only as a last resort. In today's tough job market, however, the family business may be the only place for some kids to find work. As this Practice Alert points out, employing a child may generate tax-savings regardless of how the family business is organized. Although the focus is on seasonal or part-time employment, the rules in the article also apply if the child works for the family business full-time.

Income shifting. Regardless of how a business is organized, its owners may be able to turn some of their high-taxed income into tax-free or low-taxed income by employing their children. The work done by the children must be legitimate, and the amount that the enterprise pays them must be reasonable for the wages to be deductible.

RIA illustration: A business person in the 33% tax bracket for 2010 hires her 17-year-old son to help with office work full-time during the summer and part-time into the fall. He earns $5,700 during the year (and doesn't have earnings from other sources). If that $5,700 otherwise would be paid to the business person, she saves $1,881 (33% of $5,700) in income taxes at no tax cost to her son, who can use his $5,700 standard deduction for 2010 to completely shelter his earnings.

Family taxes are cut even if the child's earnings exceed his or her standard deduction. That's because the unsheltered earnings will be taxed to the child beginning at a rate of 10%, instead of being taxed at the parent's higher rate.

Kiddie tax implications. The kiddie tax applies to the child if he or she does not file a joint return for the tax year and (1) hasn't reached age 18 before the close of the tax year or, (2) his or her earned income doesn't exceed one-half of his support and the child is age 18 or is a full time student age 19-23. (Code Sec. 1(g)(2)1). Thus, employing a child age 18 or a full-time student age 19-23 could cause his or her earned income to exceed more than half of his or her support. This, in turn, could help to avoid the kiddie tax on the child's unearned income (there is no earned income escape hatch from the kiddie tax for children under age 18).

Even if the kiddie tax applies, it only causes a child's investment income in excess of $1,900 (for 2010) to be taxed at the parent's marginal rate. It has no impact, however, on the child's wages and other earned income, which can be sheltered by the child's standard deduction.

Retirement plan savings. 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 2010, the child can make a tax-deductible contribution of up to $5,000 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child's age, and the number of hours worked.

Tax savings via education credits. Additional intra-family tax savings in the form of education credits may be available.

For 2010, taxpayers may claim an American opportunity tax credit (AOTC)/Hope scholarship credit equal to 100% of up to $2,000 of qualified higher-education tuition and related expenses plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. Thus, the maximum AOTC) Hope scholarship credit is $2,500 a year for each eligible student. (Code Sec. 25A(a)(1), Code Sec. 25A(i)(1))

The AOTC/Hope credit may be elected for a student's expenses for 4 tax years, and only for students who have not completed the first 4 years of post-secondary education as of the beginning of the tax year. (Code Sec. 25A(b)(2), Code Sec. 25A(i)(2))

Subject to an exception, 40% of a taxpayer's otherwise allowable AOTC/Hope credit for 2010 is refundable. No portion of the credit is refundable if the taxpayer claiming the credit is a child subject to the kiddie tax under Code Sec. 1(g) or a resident of a U.S. possessions (who instead claim the credit where they reside). (Code Sec. 25A(i)(6))

Taxpayers may elect a Lifetime Learning credit equal to 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit for a tax year is $2,000, regardless of the number of students. (Code Sec. 25A(a)(2), Code Sec. 25A(c)(1)) For 2010, the credit is phased out ratably for taxpayers with modified AGI from $50,000 to $60,000 ($100,000 to $120,000 for marrieds filing jointly).

Where a parent pays the college education expenses of a child whom he claims as a dependent, only the parent may claim the education credits (if otherwise eligible). However, if a parent is eligible to but does not claim a student as a dependent, the student may claim the education credit for qualified expenses paid by him or the parent. (Reg. § 1.25A-1(f)(2), Ex. 2; IRS Publication 970, 2009, pg. 15)

RIA recommendation: It may pay for a parent not to claim the student as a dependent if (1) the parent can't claim education credits because of high modified AGI, and (2) the student pays or is deemed to pay the expense and has sufficient tax liability (e.g., from summer or part-time employment) to claim the credit.

RIA illustration: Mr. and Mrs. Green have AGI of $250,000 and are in the 33% bracket. For 2010, claiming their college-freshman son as a dependent would save $1,204.50 in taxes (33% of $3,650 dependency exemption for the son). The Greens spend $24,000 on the son's AOTC/Hope-credit-eligible qualified tuition, and the son has $10,000 of taxable income from his salary working for the family business. The Greens can't claim an education credit for their child because of their high income and would be better off not claiming their son as a dependent. This way, the son may completely eliminate his $1,081.25 tax liability (10% of $8,375 taxable income, plus 15% of the $1,625 balance). He also may claim a refund for another $1,000 of the AOTC/Hope credit (40% of $2,500), so the total credit (and total savings to the child, is $2,081.25, versus the $1,204.50 the Greens would save if they claimed their son as a dependent.

RIA caution: If a parent is eligible to claim child as a dependent but doesn't, the child still cannot claim an exemption for himself.

Income tax withholding. Regardless of how the family business is organized, it probably will have to withhold federal income taxes on the child's wages. Usually, an employee who had no federal income tax liability for the prior year, and expects to have none for the current year, can claim exempt status. However, exemption from withholding can't be claimed if (1) the employee's income exceeds $750 and includes more than $250 of unearned income (such as dividends), and (2) the employee may be claimed as a dependent on someone else's return (whether or not he actually is claimed). (Instructions to Form W-4 for 2010) Keep in mind that the child probably will get a refund for part or all of the withheld tax when he or she files a return for the year.

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. (Code Sec. 3121(b)(3)(A)) This can generate some savings for a parent who runs an unincorporated business. For example, let's say a sole proprietor who usually takes $120,000 of earnings from the business pays $4,750 to her 17-year-old child in 2010. The sole proprietor's self-employment income would be reduced by $4,750, saving her $137.75 (the 2.9% HI portion of the self employment tax she would have paid on the $4,750 shifted to her child). This doesn't take into account a sole proprietor's income tax deduction for one-half of his or her own social security taxes. That's on top of the $363.37 (.0765 × $4,750) in employee FICA that the child saves by working for Mom instead of someone else. 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 his 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. The children are subject to the same rules that apply to all other employees.

RIA caution: The Hiring Incentives to Restore Employment Act (HIRE Act, P.L. 111-147) carried two valuable incentives for employers that boost payroll this year: a payroll tax holiday for employers that hire unemployed workers; and an up-to-$1,000 tax credit for keeping such new hires on the payroll for at least one year. Neither of these tax breaks is available for hiring a child (see Federal Taxes Weekly Alert 05/06/2010).

Source: Federal Tax Updates on Checkpoint Newsstand tab 5/20/2010

Do you get a payroll tax holiday and retention credit for hiring your spouse?

Practice Alert

The Hiring Incentives to Restore Employment Act (HIRE Act, P.L. 111-147) carried two valuable incentives for employers that boost payroll this year:

· a payroll tax holiday for employers that hire unemployed workers;

· and an up-to-$1,000 tax credit for keeping such new hires on the payroll for at least one year.

Practitioners have raised the question as to whether these tax breaks apply if a business person hires his or her formerly unemployed spouse. As this Practice Alert explains, the answer in many instances will be “yes.”

Background. Under Code Sec. 3111(d), as amended by HIRE Act Sec. 101(a), qualified employers are exempted from paying the employer 6.2% share of Social Security (i.e., OASDI) employment taxes on wages paid in 2010 to a newly hired qualified individual. This is an individual who:

1. begins employment with the employer after Feb. 3, 2010 and before Jan. 1, 2011;

2. certifies by signed affidavit, under penalties of perjury, that he or she hasn't been employed for more than 40 hours during the 60-day period ending on the date employment begins with the qualified employer;

3. does not replace another employee of the employer (unless that other employee left voluntarily or for cause); and

4. is not related to the qualified employer in a way that would disqualify the individual for the work opportunity tax credit (WOTC) under Code Sec. 51(i)(1). (Code Sec. 3111(d)(3))

The payroll tax relief applies only for wages paid with respect to employment beginning on Mar. 19, 2010 (the day after the HIRE Act was signed into law by the President) and ending on Dec. 31, 2010. The payroll tax holiday doesn't apply for wages paid during the first calendar quarter of 2010. Instead, the amount by which the qualified employer's OASDI tax for wages paid during the first calendar quarter of 2010 would have been reduced if the payroll tax holiday had been in effect for the first quarter is treated as a payment against the employer's OASDI tax for the second calendar quarter of 2010.

A qualified employer is any employer other than the U.S., a state, or a political subdivision of a state (i.e., a local government, or an instrumentality). (Code Sec. 3111(d)(2)(A)) However, a public institution of higher education is a qualified employer even though it is a government instrumentality. (Code Sec. 3111(d)(2)(B)) A qualified employer may elect, in the manner that IRS requires, not to have the payroll tax holiday apply. (Code Sec. 3111(d)(4)) Unless the employer elects out of the payroll holiday, wages paid or incurred to a qualified individual won't qualify for the WOTC during the one-year period beginning on the date that the qualified employer hired the individual. (Code Sec. 51(c)(5))

Popping the question. Does the payroll tax holiday apply if the taxpayer (e.g., a sole proprietor or someone operating a business as a corporation) hires a spouse as a bona fide employee? Although it's not clear that Congress intended this result, the answer is “yes,” assuming the conditions highlighted above are met.

Reasoning. Under condition (4), above, an individual cannot be an “individual described in Code Sec. 51(i)(1) (applied by substituting 'qualified employer' for 'taxpayer' each place it appears.” The fact is that while Code Sec. 51(i)(1) casts a very wide net in preventing related parties from qualifying, it does not include a spouse within its rule.

The portions of Code Sec. 51(i)(1) that are most likely to be relevant (i.e., situations other than those dealing with estates and trusts) are as follows (applied by substituting 'qualified employer' for 'taxpayer'):

· Under Code Sec. 51(i)(1)(A), an individual can't bear any of the relationships described in Code Sec. 152(d)(2)(A) through Code Sec. 152(d)(2)(G) to (1) the qualified employer, or, (2) if the qualified employer is a corporation, to an individual who owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation, or, (3) if the qualified employer is an entity other than a corporation, to any individual who owns, directly or indirectly, more than 50% of the capital and profits interests in the entity, (determined with the application of Code Sec. 267(c)).

· Under Code Sec. 51(i)(1)(C), an individual can't be a dependent (described in Code Sec. 152(d)(2)(H)) of the qualified employer, or, if the qualified employer is a corporation, of an individual described in Code Sec. 51(i)(1)(A).

Code Sec. 152(d)(2)(A) through Code Sec. 152(d)(2)(G) enumerate the taxpayer's children or their descendants, siblings or step-siblings, parents or a parent's ancestor, step-parents, nephews, nieces, uncles, or aunts, and in-laws. They don't mention a spouse. Also a person's spouse isn't his or her dependent, so Code Sec. 51(i)(1)(C) doesn't apply. So there's no rule in the Code barring the payroll tax holiday from being claimed for a person just because he or she is a spouse.

This conclusion is bolstered by IRS's recently issued Form W-11, Hiring Incentives to Restore Employment (HIRE) Act Employee Affidavit, which newly hired, but formerly unemployed, workers must sign (or its equivalent) in order for their new employers to treat the workers as qualified individuals (see Federal Taxes Weekly Alert 04/15/2010). The brief instructions to the Form essentially restate the Code Sec. 51(i)(1) restrictions and don't mention spouses. If IRS thought spouses shouldn't qualify for the payroll tax holiday, presumably it would have said so.

Retention credit applies, too. HIRE Act Sec. 103 also provides employers with an up-to-$1,000 tax credit for retaining qualified individuals, as defined for payroll tax holiday purposes. The workers must be employed by the employer for a period of not less than 52 consecutive weeks, and their wages for such employment during the last 26 weeks of the period must equal at least 80% of the wages for the first 26 weeks of the period. If a spouse is a qualified individual under the payroll tax holiday rules, and works for the requisite period of time, then the retention credit also should apply to him or her.

RIA caution: Depending on family relationships, there may be situations where a spouse will not qualify for either HIRE Act tax break. For example, if Dad owns 60% of a corporation, and Son who runs the company owns the 40% balance, then the corporation can't claim the payroll tax holiday or the retention credit if it hires Son's wife. In this situation, the wife is treated as “related” to a more than 50% owner of the qualified employer and therefore is ineligible under (Code Sec. 3111(d)(3)(D) and Code Sec. 51(i)(1)(A).

Source: Federal Tax Updates on Checkpoint Newsstand tab 5/3/2010