Five Tips to Minimize Your Family’s Tax Burden

Parents: Did you know that you can hire your kids in your small business and reduce your taxes?

Hiring your children if you own your own business is a great tax planning strategy, but it’s more than just a tax deduction. Here are a few ways you can save taxes by hiring your children in your small business:

1. You get a tax deduction for the wages you pay your kids, which reduces your taxable income

2. By paying your children, you are effectively transferring income from your higher tax bracket to your childrens’ lower tax bracket

3. You reduce your self employment income, thus you also reduce your self employment tax

4. Your kids may not owe any tax on the amount you pay them, depending on how much they earn and whether you claim them as a dependent or not (in 2009, dependent children can earn up to $5,700 before they will owe any income tax)

5. Paying your children a wage allows them to open an IRA or Roth IRA, which gives them a jump start on saving for retirement, college and other goals

If you have entrepreneurial kids, consider starting the business in your name and hiring your children instead of having the kids own the business. This will reduce your family’s overall tax burden.

Why would it matter who owns the business? Well, if you are self employed, you have to pay self employment tax on your net earnings over $400. This rule applies to both adults and children, so there is no advantage to being a kid when you’re self employed. However, kids have a huge advantage if they earn wages paid from an employer. Why? Well, kids don’t have to pay taxes on the first $5,700 of earned income, even if they are claimed as a dependent on their parents’ tax return.

Here’s an example:

Let’s assume Teddy, who is 14 years old, has a web design business. In 2009, he expects to earn $5,000 from this business after all of his expenses.

If Teddy is the owner, he is considered self employed and will have to pay 15.3% in self employment tax on this income. Assuming this is his only income, he won’t owe any federal income tax because his total earnings are less than the standard deduction amount ($5,700 in 2009), but he will still have to pay self employment tax on the net profit. Teddy’s total tax in this example will be $765.

Now let’s assume that Teddy’s dad is the owner of the business and he hires Teddy to do the work. Teddy still makes $5,000 from this business, but because he is an employee instead of the owner of the business, he doesn’t have to pay self employment tax. Teddy’s dad will report the $5,000 in income on his tax return, but he gets to deduct the $5,000 he pays Teddy to work in the business, so dad won’t owe any tax on this income. In addition, because Teddy is under 18, Teddy’s dad doesn’t have to pay payroll taxes on him. Finally, because Teddy earned less than the standard deduction, his total tax liability will be zero.

In this example, the family’s total tax savings by having the business in the father’s name and having the child as an employee instead of the owner is $765.