How the TCJA Benefits Parents Who Employ Kids

If your small-business-owning clients employ their adult children, they're in luck: The Tax Cuts and Jobs Act will reward this decision. Julian Block continues his four-part series with an in-depth look at the changes in the tax law your clients should know about.

Jan 13th 2021
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In a previous column, I discussed often-overlooked tax breaks available in 2021 for freelancers, consultants and other self-employed individuals who pay their sons and daughters reasonable wages for work actually done by the children on behalf of their businesses. Adding children to payrolls keeps businesses profits within families while shifting some from higher brackets of parents to lower brackets of sons and daughters.

This column focuses on the highlights of a recent law change that makes it even more advantageous for parents to employ their sons and daughters. The change (part of the Tax Cuts and Jobs Act (TCJA) that President Trump signed near 2017’s close) significantly increases the standard deduction that’s available to individuals who don’t use Form 1040’s Schedule A to itemize their deductions for things like charitable contributions and real estate taxes. 

Standard deduction amount authorized on 2021 1040s due in 2022 for teenagers who receive wages or other kinds of earned income. Their standard deduction is $12,550, an amount that’s “indexed,” meaning the IRS annually adjusts it to reflect inflation. For 2020, it was $12,400.

How revised rules help freelancer Nadine. Suppose she hires Eli, her 14-year-old son, to work in her office after school, on weekends and during school vacations. She pays him $10,000.

To keep things simple, he’s a teenager without other earnings from, for instance, babysitting, delivering newspapers, or mowing lawns. Nor does he receive investment income like interest and dividends. 

How does a standard deduction of $12,550 help someone like Eli? It erases income taxes on the first $12,550 he receives from wages.

Eli can use those earnings in a variety of ways. They include opening a Roth IRA to stash money for retirement. More in a subsequent column on retirement accounts.

When does the tax code authorize an impatient IRS to cut itself in for a share of Eli’s earnings? Only when they exceed $12,550, a bite that’s bearable.

What happens to the amount that exceeds $12,550? It first falls into the bottom income-tax bracket of 10 percent for a single person, which applies to taxable income of up to $9,950. The next bracket of 12 percent applies if Eli has taxable income between $9,051 and $40,525.

2021’s markers for Nadine and Eli. Not until his taxable income exceeds $40,525 (an unlikely scenario, for a part-time teenage employee) would he move beyond the 12 percent bracket and ascend to the relatively lofty 22 percent bracket.

What about Nadine? Suppose she’s in a combined federal and state bracket of 30 percent. Her deduction for Eli’s wages of $10,000 decrease her income taxes by $3,000. Just how much Nadine actually saves depends on whether Eli’s wages are subject to Social Security and other payroll taxes.

U.S. News & World Report on taxing children. Since minors can’t vote, is it legal to tax their income? That question of “taxation without representation” was posed to the Treasury Department by a taxpayer. Treasury’s written reply: “Congress represents all Americans, including those who cannot or do not vote.”–Jan. 9, 1989

“Using your child as a tax shelter may sound Dickensian, but there is nothing wrong or illegal about it.”—Jan. 23, 1984

Stay tuned for future columns. The next one alerts Nadine and Eli to additional tax breaks like exemptions from Social Security taxes for both and Roth Individual Retirement Accountants for him.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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