If you employ your children in your business, take advantage of some important tax benefits available to you. For one thing, the IRS allows parents to deduct reasonable wages paid to minor children who work in their businesses.
The main tax benefit is to allow business owners "to shift income out of the corporation to the child, who can probably shelter that income from tax entirely," says Mark Watson, a partner in KPMG's personal financial planning practice in Washington, DC.
Keep in mind that there are some requirements and guidelines you must follow to properly qualify for the deduction. For example, it's important to document the type of work your children do and demonstrate that it's worth what they're being paid. To determine what's a reasonable sum, figure out what you are paying other people in your company doing the same job.
It's also important to draw up a job description for the work your kids perform and make sure what they are doing is necessary for the business. Tax experts also recommend putting them on the payroll as you do with all your employees. You'll also want to keep detailed time records demonstrating how much they are working, and be sure to complete a W-4 form for each of your children. Children under 18 can earn up to $4,400 this year without owing federal income tax. Along with time sheets, keep canceled checks or pay stubs.
For sole proprietorships, there's another benefit if you employ your children-namely, wages paid to a child under age 18 are not subject to Social Security or Medicare taxes. That means your child is not responsible for paying FICA taxes on his or her wages, nor are you required to pay the employer's share of these taxes.
Another perhaps more important tax benefit is the opportunity for working children to put up to $2,000 of earnings or their total earned income, whichever is lower, into a Roth IRA each year. One of the biggest pluses of establishing a Roth IRA comes in the withdrawal of funds at retirement. With a Roth IRA, there is no deduction for contributions, but growth is tax-free. Tax-free withdrawals are allowed after the account has existed for five years and the account holder reaches age 59.
A Roth IRA represents "a home run" as far as tax planning is concerned, says Watson. Why? Because the money invested in a Roth IRA is sheltered from federal taxes through the standard deduction ($4,400). In essence, children who have earned income are contributing money they haven't paid federal taxes on, the funds are allowed to grow tax-free, and they can be withdrawn free of federal taxes. Says Watson: "There aren't many tax benefits as good as this one."
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.