Do your children help out in your business occasionally? You may be thinking…”they owe me, why should I pay them?!”. However, compensating them can actually save money in income taxes. The strategy is to pay them no more than the standard deduction (2012 – $5950). The W-2 they receive will not trigger a tax filing requirement (IF they have NO other taxable income), and the wages and employer payroll taxes, if applicable are 100% tax-deductible to your business.
So what about the payroll taxes? If you are a sole proprietor or a general partnership, and your child is under 18, no payroll or income taxes are required to be paid or withheld. The only paperwork to file is a W-2 at year-end to report their gross wages. So it costs almost nothing and will save you self-employment and income taxes due to the deduction, which is a savings of 12.3% + your effective income tax rate!
What if you are incorporated? In this case, the standard payroll taxes and tax filings will apply. The payroll tax will be approximately $934 on a salary of $5950 (15.7% for 2012 give or take a few % points depending on your unemployment rate).
What are the potential tax savings? If you pay a combined federal and state effective income tax rate of 30% (and climbing by the day) , then this results in a potential tax savings to you of approximately $2442 due to the deduction for the wages and employer taxes combined. So you just saved over $1500 in taxes for just one child’s wages (the net of the payroll tax cost and your tax reduction). And remember if you are a sole proprietor with no payroll tax requirement, this savings is even higher.
Do be sure and consider the processing costs of implementing this strategy. If you already have payroll then extra costs will be minimal to add an employee or two. If these are your first employees, the cost should still be minimal and less than the tax savings, but this all depends on your own costs, income tax rate, etc. So be sure and do a quick cost analysis before pulling the trigger.
If the numbers work out (and they usually do) this is a great way to turn otherwise non-deductible necessities such as school supplies, food and clothing into at least partially deductible business expenses by paying it out in wages.
This is also a great way to start a Roth IRA account for the child if the cash is not needed for expenses.
I hope this is helpful! Stay tuned for more year-end tax strategies.