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June 6 , 2005 - As an owner of a business I have heard that it can benefit me to put my children on the payroll. Is this true and what are the ways that I will save?

You may be able to turn high-taxed income into tax-free or low-taxed income, achieve social security tax savings (depending on how your business is organized) and even make retirement plan contributions for your child. Here are the key considerations.

Turning high-taxed income into tax-free or low-taxed income. You can turn some of your high-taxed income into tax-free or low-taxed income by shifting some of your business earnings to a child as wages for services performed by him or her. The work done by the child must be legitimate, and the amount you pay the child must be reasonable for your business to deduct the wages as a business expense.

For example, suppose you are operating as a sole proprietor is in the 35% tax bracket for 2005. You hire your 17-year-old daughter to help with office work full-time during the summer and part-time into the fall. She earns $5,000 during the year (and doesn't have earnings from other sources). You saved $1,750 (35% of $5,000) in income taxes at no tax cost to your daughter, who can use her $5,000 standard deduction for 2005 to completely shelter her earnings.

Keep in mind that bracket-shifting works even if the child is under age 14. The kiddie tax only causes a younger child's investment income in excess of $1,600 (for 2005) to be taxed at the parent's marginal rate. It has no impact, however, on the child's wages and other earned income, which can be sheltered by the child's standard deduction.

Social security tax savings, too. If your business is not incorporated, you can also save some self-employment (i.e., social security) tax dollars by shifting some of your earnings to a child. That's because employment for FICA tax purposes doesn't include services performed by a child under the age of 18 while employed by a parent. For example, let's say you are a sole proprietor who usually takes $120,000 of earnings from the business and you pay $5,000 to your 17-year-old child in 2005. Your self-employment income would be reduced by $5,000, saving you $145. This doesn't take into account your income tax deduction for one-half of your own social security taxes.

A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by his or her parent. Note that there is no FICA or FUTA exemption for employing a child if your business is incorporated or a partnership that includes non-parent partners. However, there's no extra cost to your business if you're paying a child for work you'd pay someone else to do, anyway.

Retirement benefits. Your business can also provide your child with retirement benefits. For example, if it has a simplified employee pension, a SEP contribution can be made for the child up to 25% of his or her earnings. The child's participation in the SEP won't prevent the child from making tax-deductible IRA contributions as long as adjusted gross income (computed in a special way) is below the level at which deductions for IRA contributions begin to be disallowed. For 2005, that figure is $50,000 for a single individual.

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