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May, 2006 Tax Tip

Hire Family Members & Save Taxes

Did you know that hiring your child or another family member in your business can save taxes for both the business and for the family as a whole? The end of the school year and the approach of summer make it an ideal time to put your children to work for you in a win-win situation. The business saves taxes because it can deduct the compensation as a business expense, just as it could if the work was done by an unrelated party. The family saves taxes because the income is spread over more taxpayers, particularly those in lower tax brackets. Moreover, if the business is operated as a sole proprietorship, there could also be a savings in self-employment tax.

 

To deduct the compensation the employment relationship must be bona fide and the salary must be reasonable for the services provided. If these requirements are not satisfied, the deduction is not allowed.

Employing a child generally reaps the largest benefits. First, a child is likely to be in a lower tax bracket than the parent. Second, the basic standard deduction for a child who is a dependent is available to the extent of earned income. Otherwise it is limited. For 2006, the standard deduction for a person claimed as a dependent on another's return cannot exceed the greater of $850 or earned income plus $300. Thus, a child who is employed can earn up to the 2006 standard deduction amount of $5,150 tax free. That's not all - if the child contributed the maximum $4,000 to an IRA, he or she could earn up to $9,150 tax free and have a retirement plan started!

If you are concerned that your child will lose dependent status, don't be. There is no ceiling on how much your child can earn if he or she is under 19 or a full-time student under 24.

Another benefit in hiring family members can result from lower tax cost for insurance. For example, a self-employed person who provides health insurance to his spouse or other family member as an employee can deduct the cost of the coverage as a business expense, again so long as there is a bona fide employment relationship. Similarly, in certain corporations or in a proprietorship, income earned from employment can qualify a family member for fringe benefits and retirement benefits that are deductible by the business and non-taxable to the employee. This can significantly reduce the cost of providing benefits such as health insurance for family members.

If the family business is organized as a partnership or as a sole proprietorship, the benefits of hiring your child can be obtained at minimal cost in employment taxes. No Social Security taxes are due if a child under age 18 performs services for a parent in the parent?s business, and no FUTA taxes are due when services are performed by a child under age 21.

So if you think your children are costing you an arm and a leg, why not use them for financial gain to the extent possible?



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