Many small businesses get the whole family involved. Parents bring children into a business for help and to teach the kids money-making skills. When the children grow up, they may take over the family business and then pass it on to their offspring.
The Legal Structure of a Family Business
Either spouse can own a sole proprietorship. If other family members share ownership, the business must be organized as a partnership, limited liability company, or corporation.
These more complex forms of doing business offer families more tax and estate planning flexibility than sole proprietorship. For instance, incorporating allows family members to receive ownership benefits (such as stock dividends) even if they don't work for the enterprise. Or, forming a family limited partnership or LLC makes it easier to transfer business ownership to family members gradually over time and save both income and estate taxes.
Families can even combine several different types of business structures to best -distribute tax benefits. For instance, a partnership with several siblings can own and rent a building to a corporation owned by their parents. Whether or not multiple entities make sense depends on the tax situations of all the family members.
Generally, whether the complications of forming several entities are worth it hinges on the -income splitting ideas discussed below.
Income Splitting Lowers Taxes
Family members often pool their resources to run small businesses. For many, this provides not only a good living, but also a sense of security and closeness. As a bonus, family ventures can also bring tax savings for the family unit.
One technique known as income splitting shifts income from higher bracket taxpayers-usually parents-to lower ones-usually children or retired grandparents. Obviously, these strategies depend on cooperation and trust between family members.
Legality of Hiring Your Kids
It's perfectly legal to hire family members to work in the business for a salary. Courts have supported parents hiring their minor children as long as they give them real work to do. Employing kids or other relatives is okay-as long as the pay isn't outrageous. Following are the basic tax code rules on hiring your children or parents.
Tax Benefits of Hiring Your Kids
Putting your children to work in your business can reduce your family's tax bill. Paying your kids reduces the business profits that would otherwise be taxed at your tax rate (which is always higher than your kids' rates).
A minor can earn up to $5,150 (2008) without owing taxes to the IRS. Then, the tax rate starts at 10%. As long as the -income is earned by a child who works in the family business, the kiddie tax (tax on a child's investment income discussed -below) doesn't apply.
Besides Junior's lower tax bracket, no FICA (Social Security and Medicare) taxes are due when he works for Mom or Dad's business. Ditto for FUTA (federal and state unemployment) taxes when Junior is under 21.
In other words, there's no tax cost for putting Junior on the payroll. If Junior saves up or uses the money for things the parents would be buying anyway, this is money in the family piggy bank.
EXAMPLE: Laura, a single mother and the sole proprietor of PhotoLand, earns $380,000 per year, putting her in the 35% tax bracket. Her 17-year-old daughter, Louisa, helps out -after school, on weekends, and all summer. Louisa is paid $20,000 over the year.
Louisa files a Form 1040 tax return, taking her personal exemption and claiming the standard deduction. She owes $1,735 (10% on her first $7,825 of taxable income and 15% on the remainder) in income taxes and no FICA tax.
If Laura hadn't hired Louisa, and -instead took the $20,000 in -income herself, she'd pay taxes of $7,580 ($7,000 in income taxes at 35% tax rate plus an additional $580 in self-employment taxes-2.9% for Medicare).
Total family federal tax savings: about $5,800. The tax deal can be even better if Louisa opens an IRA. (See - just below.)
TIP: Save even more with an IRA for your child. An individual retirement account can be established for any working child who earns wages. Putting money into an IRA makes tax sense even if the child takes it out long before retirement, say for college.
Paying Your Children Legitimately
Courts have okayed kids as young as seven getting paid for simple chores like taking phone messages or cleaning the office windows. (I don't know about your kids, but I shudder at the thought of a seven-year-old answering my business phone.) Children can be paid a reasonable sum for their work; reasonable pay depends on the facts and circumstances of each case. My advice: Don't try to pay and deduct more than a few thousand dollars per year to any of your children under age 12.
EXAMPLE: Dr. Moriarty (his real name-not Sherlock Holmes's nemesis) hired his four teenagers to do clerical work for his medical practice. An IRS auditor said this was a mere subterfuge to deduct the kids' allowances as a business expense. The tax court overruled the IRS, saying it was all legal as long as the kids did real work and were paid reasonable wages. (James Moriarty, TC Memo 1984-249.)
Type of work. The kind of work done by the child-such as washing the company car, filing, or going to the mailbox-doesn't matter, as long as it's a task a business customarily would pay someone to do. Duties should reflect the age and training of the children. While it is fine to pay a 14-year-old to do computer inputting, it wouldn't wash for an eight-year-old. But it's okay to hire your precocious 13-year-old to do filing even if you might not hire someone else's 13-year-old for the job.
Rate of pay. Generally, don't pay your child more than you would a stranger, although there is some wiggle room. If you pay little Susie $7 per hour, and you could realistically find someone else to do it for $5.50, an auditor will likely let it pass. But you are pushing the envelope if you pay Susie $20 per hour.
Schedule of pay. The payments to your kids should match up to a work schedule. This can be tied to school vacations, after-school time, or holidays. If you make only one or two lump sum payments in a year, an auditor might think that you are trying to fudge on your taxes instead of legitimately paying Junior for work.
Making Your Kids Co-Owners
You can also shift business income from higher-bracket family members to lower ones by giving your children stock in your corporation. Children don't have to work in the family business with this income-splitting technique.
Stock ownership is treated as an investment in the business by the family member, even if the child didn't pay for the stock. The primary drawback to giving your children stock is that you must irrevocably transfer the stock to them. You have no legal right to take it back later.
Children can receive dividends on their shares of stock in the family business. Dividends are taxed according to how old the kids are, with a break for kids under age 18. For more information, see IRS Publication 501, Tax Rules for Children and Dependents.
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