Although many small and large business owners are already aware of this strategy, some things are good enough to revisit once in a while.
This tax strategy can have the following ripple effects for your children:
Increasing their responsibility
Allows the business owner to show them how to run the business, while potentially providing tax benefits to ‘the family’.
Allows children the opportunity to get a head start on tax advantaged retirement plans such as contributions to IRA’s.
How it works:
Strategy 1: Income earned by children may be tax free (federally) to the extent they do not exceed $5,450.
Example: Sam who works for her mother’s company and is claimed as a dependent of her mother, earns $4,000 cleaning the office building every week. When Sam goes to file her return, although she is a dependent of her mother she still gets her standard deduction up to her W-2 earnings (limited to the first $5,450). So her federal income tax is $0. Her mother would still have to pay Social Security tax on the income, but usually this is a small price to pay to transfer small dollar amounts to your daughter who also now cleans the office (a win-win situation).
Strategy 2: Earned income contributed to the child’s IRA.
Example 2: Sam has worked in the office for a few years and now does filing duties as well as cleaning. Because of this promotion, her annual income has increased to $9,000. While Sam still receives a $5,450 standard deduction, there is another trick she can use to shelter some of that income (if not all). She can contribute (or her parents) up to $5,000 to a traditional IRA account to reduce her taxes by $355*. Or, she can contribute up to $5,000 to a Roth IRA and receive the money tax free (at a later date) for college, or a first home purchase in the future (Sam would give up the immediate tax savings of $355, and there are certain restrictions on these types of distributions).
* Tax without IRA = (9,000 – 5,450) x 10%
* Tax with traditional IRA = (9,000 – 5,450 – 5,000) x 10% (cannot be less than zero)