Save Family Income by Hiring Your Kids

1. Introduction

Do you ever feel like the harder you work and the more you make, the government is there to take a bigger chunk of your income?

Well, recent times have demonstrated this phenomenom more so than you have seen for a long time. Not since the late 1980’s have sales been so good for most Real Estate Professionals.

In this article we will introduce one way that a Real Estate Professional can leverage their unique profession to minimize their taxes while maximizing their available tax deductions and their family’s income.

2. How It Works

An owner of a business, such as a Real Estate Professional, can save family income and payroll taxes by putting junior family members on the payroll. Family income tax can be saved by shifting some of the earnings of the business to the child as wages for services performed by the child.

Some of you may be familiar with the kiddie tax which causes an under-age-14 child's investment income in excess of $1,300 to be taxed at the parent's marginal rate.

It is surprising, however, that most of you are not aware that the kiddie tax has no impact on the child's earned income, which can be sheltered by the child's standard deduction ($4,300 in 1999).

3. Examples

Illustration #1

John and Mary are successful Real Estate Professionals who will jointly earn $135,000 in net self-employment income in 1998. Their daughter Lisa, who is 16 years old, has been helping them throughout the year with telemarketing and mailers. Lisa is a full time high school student.

If John and Mary pay Lisa $4,000 for her work in 1998, then “the family” will save $1,240 in federal taxes (31% marginal tax bracket) and $372 in California taxes (9.3% marginal tax bracket) for a total savings of $1,612 in taxes.

A Real Estate Professional parent running an unincorporated business can also save social security tax by shifting some of their earnings to their children.

That's because employment for FICA tax purposes doesn't include service performed by a child under the age 18 in the employment of his mother or father. That’s an additional 15.3% savings.

Illustration #2

In illustration #1, John and Mary would have been responsible for self-employment (Social Security and Medicare) taxes on the $4,000 if they had not paid this to Lisa. This represents an additional family savings of $612 (12.4% in Social Security taxes and 2.9% in Medicare taxes) for a total family savings of $2,224.

In fact, payments for the services of a child under the age of 18 who works for his or her parent in a trade or business (sole proprietorship or certain partnerships) are not only exempt from social security and Medicare taxes, but are also exempt from federal and state unemployment taxes (i.e. no payroll taxes). Just as nice, payments for the services of such a child are not even subject to workmen’s compensation insurance.

By using the child’s Individual Retirement Account (IRA) deduction, the Real Estate Professional family can magnify the savings even further.

By keeping the child on the payroll for a longer period and paying them an additional $2,000, one could shelter the additional amount from tax by having the child make a tax-deductible contribution to an IRA account. This account, by-the-way, can grow tax deferred and later be withdrawn for college funding or for the purchase of the child’s first home, penalty free!

Illustration #3

In the previous illustrations, Lisa’s pay was increased to a total compensation of $6,250. This will be totally sheltered by Lisa’s standard deduction of $4,250 and her IRA deduction of $2,000. Resulting in a family savings of $3,475 (31% federal income tax savings; 9.3% state income tax savings; and 15.3% in federal self-employment tax savings).

By now some of you may be asking about the personal exemption deduction. Isn’t that also available to the child to offset an additional $2,750 (1999 per person amount). The answer is no, if they are still the parents’ dependent. But don’t fret, it is available to the family on the parent’s return.

Suppose the child is eager to work and works and earns more than can be sheltered by the standard deduction and an IRA deduction. The result would still be very good for the family. Rather than being taxed at the parent's higher rate, the unsheltered earnings would be taxed to the child, who will file as a single taxpayer, beginning at a rate of 15%.

Illustration #4

In the previous illustrations, suppose Lisa worked really hard and long and thus her pay was increased to a total compensation of $12,000. This will now be partially sheltered by Lisa’s standard deduction of $4,250 and her IRA deduction of $2,000.

The $5,750 balance will only be subject to a 15% federal and 1% state tax, resulting in a total family savings of $5,752 (31% federal income tax savings on $6,250; 16% federal income tax savings on $5,750; 9.3% state income tax savings on $6,250; 8.3% federal income tax savings on $5,750; and a 15.3% savings in federal self-employment taxes on the entire $12,000).

Most successful self employed Real Estate Professionals have established a retirement savings account. Given the existence of such a plan, the business can also provide the child with retirement benefits.

For example, if the parent-employer has a simplified employee pension plan, a SEP contribution could be made for the child of up to 15% of the child's earnings.

The child's participation in the SEP would not prevent the child from making tax deductible IRA contributions as long as the child’s adjusted gross income (computed in a special way) is below the level at which deductions for IRA contributions begin to be disallowed. That figure is $30,000 for a single individual.

Illustration #5

In illustration #4, suppose Lisa’s compensation was $12,000 and Lisa was eligible for a 15% SEP. This will now allow for a fully deductible $1,800 contribution by her parents to Lisa’s SEP plan. This additional deduction will result in a total current family savings of $6,752 ($5,752 based on illustration #4 plus a 1,000 on the SEP).

If the parents elect to use a full KEOGH plan versus a SEP, a KEOGH contribution could be made for the child of up to 25% of the child's earnings.

Illustration #6

In illustration #4, suppose Lisa’s compensation was $12,000 and Lisa was eligible for a 25% KEOGH. This will now allow for a fully deductible $3,000 contribution by her parents to Lisa’s KEOGH plan.

This additional deduction will result in a total current family savings of $7,420 ($5,752 based on illustration #4 plus a 1,668 on the KEOGH).

A KEOGH plan, unlike a SEP, must be in existence by year-end for the year the contributions are to be made for. In addition, if an employer has a SEP or a KEOGH plan, contributions are mandatory for any employee who has earnings over an annually-indexed figure, which is $500 for '99.

However, when the plan is established, it can be set up to exclude employees who have not attained age 21 as well as those who have not performed services during at least 3 of the immediately preceding five years. Anyone intending to employ a minor family member should keep this in mind when establishing or amending their plan.

Of course, if a plan is set up without excluding those under a 21 and those without prior service, all employees, including non-family members, with compensation over the applicable dollar figure would have to be covered.

The above strategies can be implemented for a one child family, per the illustrations above, or can be magnified even further for a multi-child family. Can you imagine what this can do for your college funding needs?

The Real Estate Professional family can also benefit from a spouse’s employment role in the business. If you liked what you saw we can do with the kids, wait until you see what we can do with an employed spouse!

RealTax professionals have the knowledge and expertise to help you save your family income by hiring your children or your spouse. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.