ELITE ADVISOR BEST PRACTICES

Helping Clients Save on Taxes by Hiring Their Kids - Part Two

How it cuts clients’ income taxes

By Glenn Demby

Key Takeaways:

  • Clients who own small businesses can cut their taxes substantially by hiring their dependent children.
  • The arrangement saves taxes by shifting your clients’ business earnings, which are taxed at a high rate, to their kids’ personal earnings, which are taxed at a lower rate.
  • But for the arrangement to be legal, the children must work for the clients under “bona fide” employment arrangements acceptable to the IRS.
  • Bracket-shifting for bona fide employment works even for a child subject to the “kiddie tax” (which causes the child’s investment income in excess of $2,000 for 2014 to be taxed at the parent’s marginal rate).


As many advisors are aware, you’re allowed to deduct reasonable wages that you pay your employees as an ordinary and necessary business expense. This rule applies to wages you pay to employees who happen to be your minor, dependent children, as long as you can show that their employment is “bona fide.” In Part One of this series we looked at what constitutes bona fide employment. Now let’s look more deeply into the income tax savings your clients (and you) can accrue by being able to deduct kids’ wages.

Simply stated, hiring minor kids via bona fide employment arrangements cuts the business owners’ taxes by shifting their own business earnings, which are taxed at a high rate, to kids’ personal earnings, which are taxed at a lower rate (or maybe not taxed at all). Let’s use the following example to illustrate the resulting tax benefits.

Example

Lou Pole, CFP, hires his 17-year-old son, Tad, to help out around his one-advisor wealth management office for the summer and pays him $6,100 in wages.

Lou is in the 36.9 percent tax bracket. Tad has no other earnings.

Results: Lou saves $2,250.90 (36.9% of $6,100) in income taxes at no tax cost to his son. Tad can then use his $6,100 standard deduction for the tax year to shelter his earnings completely.

Lou can save $2,029.50 more in taxes by keeping Tad on the payroll and paying him an additional $5,500. Tad could shelter the additional income from tax by making a tax-deductible contribution to his own IRA.

Even if Tad’s earnings exceed his standard deduction and IRA deduction, unsheltered earnings will be taxed to him beginning at a rate of 10 percent, instead of being taxed at the higher rate that applies to Lou.

Bracket-shifting works even for a child who is subject to the “kiddie tax,” which causes the child’s investment income in excess of $2,000 for 2014 to be taxed at the parent’s marginal rate. The kiddie tax has no impact on the child’s wages and other earned income.

Conclusion

Remember that to realize these tax savings, the work arrangement your clients make with their minor children must be bona fide employment. The IRS is very strict about applying this rule. See Part One of this series to see what constitutes “bona fide employment” and to find out about the seven things you can tell your clients to do to ensure that their employment arrangements with their own minor children stand up to IRS scrutiny.

This article was adapted with permission from MurrayBradfordTaxInstitute.com, a site dedicated to helping self-employed taxpayers and one-owner businesses save on taxes.


About the Author

Glenn Demby is an attorney and prize-winning B2B journalist who specializes in explaining the law in plain English and providing how-to solutions to help business professionals overcome their compliance challenges. He can be reached at 203-354-4532 and at glennsdemby@gmail.com.