A perfectly legal way for freelancers and other self-employed individuals to trim taxes is to employ their children. Their salaries stay in the family, but are shifted into their lower tax bracket. The jobs also put some "jingle in their jeans," familiarize them with freelancing, and instill a bit of the old work ethic.
Responsible youngsters are able to handle all kinds of chores. Some of the more common ones include answering telephone calls, cleaning offices, addressing envelopes, filing, bookkeeping, secretarial and other clerical work, and making deliveries. Nowadays, lots of kids are more adept with computers than older employees.
The Way It Works
Imagine that your business hires Eli, your 16-year-old son, to do clerical work after school, on weekends and during school vacations. The law allows him to offset earned income with a standard deduction—the no-questions-asked amount authorized for someone who doesn't itemize. For 2014, a single person's standard deduction is $6,200. So the first $6,200 of Eli's earnings escapes income taxes. He can use the money to support himself or put away for college, a car, or a vacation.
True, earnings above $6,200 will lead to a tax liability for Eli. However, the excess falls into the bottom income-tax bracket of 10 percent, which applies to taxable income of up to $9,075. His 15 percent bracket applies to taxable income between $9,075 and $36,900. In fact, using 2014 as a marker, not until taxable income surpasses $36,900 would this part-time teenage employee move beyond the 15-percent bracket and ascend to the relatively lofty 25-percent bracket.
If you're in a combined federal and state bracket of 30 percent, hiring him lowers your income taxes by about $1,860 (30 percent of $6,200). Of course, the exact amount will depend on whether Eli's wages are subject to Social Security and other payroll taxes.
There's an additional carrot if you don't operate your business as a corporation: sidestepping Social Security and Medicare taxes on wages paid to under-age-18 sons or daughters. To qualify for the exemption, you must do business as (1) a sole proprietorship (IRS lingo for the lone owner of a full-time or part-time business that's not formed as a corporation or a partnership with a partner other than your spouse) or (2) a husband-and-wife partnership. Consequently, whatever income you're able to shift to Eli lowers your Social Security taxes.
IRS auditors are understandably suspicious of deductions for wages paid to your own children. The write-offs survive scrutiny only if you're able to establish that the children actually render services. Expect the feds to throw out a deduction for hiring, say, a six-year old to do photocopies; someone that age likely lacks the skills or discipline for office work.
Another hurdle is the "reasonableness" requirement. Wages paid to children can't be more than the going rate for unrelated employees who perform comparable tasks. That doesn't mean you have to be a parsimonious paymaster who doles out only the minimum wage. But it does mean that you have to treat your children the same as any other employee and keep the usual records showing amounts paid and hours worked. Give them W-2 forms, even if they qualify to exempt their wages from withholding for income taxes; use checks drawn on business accounts to evidence the payments. Otherwise, the IRS might contend that the payments exceeded the going rate or that your youngsters weren't bona fide employees, but merely rendering the token kinds of services that parents expect their children to perform.
About the author:
Julian Block writes and practices law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator) and an attorney. More on this topic is available from "Julian Block's Easy Tax Guide for Writers, Photographers, and Other Freelancers," available for Kindle at Amazon.com and as a print copy at julianblocktaxexpert.com.