Tax strategies Featured

10:08am EDT July 22, 2002
Hiring family members at your business could have more benefits than you're aware of. With some careful planning and documentation, your family members can avoid taxes on some of their income. Not only will it help reduce the family tax burden come April, but they can gain valuable business experience.

One of the most common tax strategies of hiring family, particularly children, is moving out of a higher income bracket into a lower one.

"If you have a child in the business who is performing services at a reasonable compensation level, you can split the income into a lower bracket," says Richard Johnson, chair of the tax group for the Nashville-based law firm of Waller, Lansden, Dortch & Davis.

Consider the following numbers: A married couple filing jointly with taxable income over $155,950 will be in the 36 percent tax bracket. A single child earning up to $25,350 will be in the 15 percent tax bracket. That's a difference of 21 percent of additional taxes that is avoided on the child's income. It also allows you to transfer some of your wealth without worrying about federal gift or estate taxes.

"If the child working is under the age of 18, there is no Social Security withholding requirement at all," notes Johnson. This also means the business does not have to pay the employer's share of those Social Security taxes either.

The services performed by the child must be part of a legitimate job within the business that otherwise would have been held by an unrelated person. The compensation must also be reasonable compared to others at the company doing similar tasks. Paying your child $25,000 a year to sort mail once a week will not be looked on favorably by the IRS.

If young children are working at the business, any money they make is considered earned income and is not subject to the "kiddie tax" that normally is applied to those under age 14. The kiddie tax affects all unearned income-from sources such as stocks and interest-in excess of $1,300. This income is taxable to the child at the parent's highest income-tax rate.

If the child works in the business, you could pay him or her $4,250 a year, which is equal to their maximum deduction. After the deduction, there would be no taxable income left, and you can still claim the $2,700 dependent child deduction on your income taxes.

Retirement planning.

Experts will tell you that it's never too early to start planning for retirement, so why not have your children who work for the business contribute to an Individual Retirement Account? Each child can contribute $2,000 or their total income, whichever is less. The IRA deduction can be combined with the standard deduction of $4,250 to yield $6,250 total of tax-free income.

Like any tax break, make sure everything is documented to answer any IRS inquiries. Write a job description for each of the children working in the business and be able to demonstrate they are worth what they are being paid.

Johnson recommends paying children on the same schedule as other employees to help avoid IRS suspicion.

"It's probably easier, record-keeping wise, to pay them with the rest of the employees, and if you do it at the end of the year as a lump sum, it may appear you are guessing what they are worth rather than paying them as you would an unrelated party," notes Johnson.

Depending on what work the child is doing, he or she may qualify to go on business trips with you and you can deduct their expenses, as long as the trip is relevant to the job. One possibility for adult children is to serve on your board of directors.

"They can receive reasonable fees for attending directors' meetings, and it will also give them a feel for how things are operating and what is going on," says Johnson. This can be especially important if you plan on handing over control of the business to the child at some point. "If they work in the company, it's better to have them work for a trusted manager and hold them accountable for their work. They'll learn to take responsibility and will get more out of the employment experience."

Talk with your accountant to find out what tax benefits your business can achieve through employing members of your family.