If you own a Schedule C business (sole proprietorship), here's a way to get the kids summer jobs and save on taxes. A Schedule C business owner can save family income and payroll taxes by putting a junior family member on the payroll. Let's look closer.

Income Shifting

What we are looking at here is "income shifting" or "bracket shifting." Shifting some of the business earnings to a child under age 18 as wages for services rendered can reduce income and employment taxes. Obviously, the work done must be reasonable for the business to get a deduction, but it doesn't have to be technical or professional in nature.

Example: One of my clients, Janet, operates as a sole proprietor and files a Schedule C for her business. This summer, Janet plans to upgrade, update, and generally clean up her business files. She also needs some "fill-in" help during the summer to cover employee vacations, etc. Janet plans to hire her 16-year-old son, Tom, and her 14-year-old daughter, Jerri, to do this work. Tom and Jerri will work full time over the summer and will each earn about $4,200.

Ready... Set... SHIFT

Janet and her husband are in the 36% tax bracket. Tom and Jerri have no other income, so their wages (that will be reported on the W-2 forms they will receive from Janet) will be offset by their standard deduction. Therefore, Tom and Jerri's earnings are completely sheltered — neither will pay ANY tax on those wages. Janet, on the other hand, will reduce her Schedule C income by $8,400. In her tax bracket, this deduction saves her $3,024 in federal income taxes. Pretty impressive, no?

Well, it gets even better. Janet will also save on Social Security (FICA) and Medicare taxes, since her net Schedule C income will now be less than $76,200. Want more good news? None of Tom and Jerri's wages will be subject to any FICA or Medicare taxes. Why? Internal Revenue Code Section 3121 clearly states that employment for FICA and Medicare tax purposes doesn't include the services performed by a child under the age of 18 in the employ of his mother or father. There is also a similar, but more liberal, exemption applicable to FUTA (Federal Unemployment Tax) payroll taxes that can be avoided by the employer of his or her children.

So, in this example, Janet's SE (Self-Employment) income will be reduced by $8,400, saving about $1,285 in SE tax. The actual SE tax savings will be slightly less than noted because Janet gets a deduction for one-half of the SE taxes paid. But I think you can see how the numbers (and savings) work. In this example, Janet and her husband will save about $4,300 in federal income taxes and SE taxes. That's more than HALF of the wages Janet will pay Tom and Jerri.

And it's quite possible that state income and employment taxes will also be avoided. That varies by state, but most states follow federal laws regarding employment taxes and which employees are subject to them. So, Janet could also realize some additional state tax savings. Sweet.

What About the Kids?

Well, remember that Tom and Jerri have no FICA tax to pay, either at the employee or employer level. And, as we already discussed, they also don't have any income tax to pay as long as their gross (and only) wages are $4,300 or less. Nice deal, eh?

Janet can save an additional $720 in income and SE taxes if she keeps the kids on the payroll for a longer period of time and pays them an additional $2,000 each. The kids could then shelter this additional income by opening up an Individual Retirement Account (IRA) and making a tax-deductible contribution. Or, the kids might simply decide to invest some of their earned income in a Roth IRA. Regardless, they'll pay virtually NO income or employment taxes on that income. And, mom and dad will do nothing but save tax dollars. If this is something you can put together in your own life, it's a very powerful tax-saving tool.

Words of Warning

A few issues that you might want to consider:

• The "kiddie tax" might come into play if your child is under age 14 and has other investment income. But, remember that the kiddie tax only applies to unearned income. Earned income is not subject to the kiddie tax, and can still be sheltered by the child's standard deduction. So check the effect of the kiddie tax, if any, before and after employment income. In general, I think you'll find that a tax-saving opportunity still exists, regardless of the kiddie tax issues.

• The child must actually perform the work and provide services. You can't put little Tom and Jerri on the payroll if they don't show up for work.

• The work performed must be directly connected with your trade or business. You can't pay Tom and Jerri from your business for doing chores around the house.

• While there are no federal rules regarding the age of the child applicable to this provision, the payments to your child must be reasonable in relation to the services rendered. Don't expect to pay the kids $150 an hour and get away with it.

• You must follow the IRS rules and regulations when you put the kids on the payroll. This means you'll need to apply for a Federal Tax ID number, file quarterly payroll tax reports, issue annual W-2 forms, and fork over any and all payroll taxes that may be required. You can't simply call your child an "independent contractor" and give him a Form 1099 at the end of the year. It doesn't work like that. If you're going to do it, do it right.

This tax dodge is a thorn in the side of the IRS. They may try to question you and your deductions. Make sure you keep appropriate records and documentation showing the hourly wages paid, the work performed, the total hours worked, and on and on. The more documentation you have, the better you'll weather the storm should the IRS come calling. You'll also want to check out your state and local employment laws. Some states have laws against "child" employment unless specific guidelines are met. Make sure that you are aware of those laws and comply with them.

Employing Adult Family Members

While not as powerful as employing the kids in terms of tax savings, this technique also works well. Even if your kids are older, or you decide to employ your parents in the business, you'll still save some tax dollars. The theory works the same, but some of the benefits may be lost in the following manner:

• If your family employee (either your child or parent) is age 18 or older, you'll have to deduct applicable FICA and Medicare taxes. In addition, you'll also have to match those FICA and Medicare deductions in the form of employer payroll taxes.

• You may have to pay Federal Unemployment (FUTA) tax on the wages paid to the family employee.

But, even if you lose some of the tax savings because of the employment tax issues, the income tax savings are still there for the taking. Say that you pay your mother-in-law $15,000 to keep your business books. If this is her sole source of income (other than her monthly nontaxable Social Security benefits), she'll pay only about $1,193 in income taxes. This business deduction can save you about $4,650 in income taxes if you are in the 31% bracket. Even factoring in the employment tax expenses, you'll still be way ahead of the game.

Employing adult family members has other benefits too:

• You can justify a higher salary for the work performed (compared to what you pay your children).

• Your adult family employees can participate in and receive even greater benefits from qualified retirement and benefit programs.

• While you'll be subject to employment taxes on the wages, those employment taxes are business expenses for your business, thereby reducing your income taxes even more.

There is no question that paying wages to family members is one of the most powerful ways to shift income to lower tax brackets and take care of the family at the same time. Make sure you don't overlook it.

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

May 5, 2000

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