Bringing your children into practice can net tax benefits

December 20, 2012

By James R. Armstrong, CPA, and Jodi Permenter, CPA

Is your practice “family owned and operated?” Optometric practices are often passed down from generation to generation.

Optometrists who allow their children to work in their practices can help their offspring to determine if they would enjoy a career in eye care and, if so, help them get some experience in day-to-day practice operations.

Moreover, they can realize some valuable tax benefits. Employing your children is an excellent way to channel income to lower tax brackets and save money for your child’s college education, as well as teach your children life skills.

Wages paid to family members are deductible business expenses, and paying your child for legitimate work performed for your business will allow you to convert your potential high tax bracket income into tax-free or low tax bracket income.

Your child’s income is generally subject to payroll taxes such as FICA and Medicare taxes. However, if you are operating a sole proprietorship or a partnership in which both partners are spouses, you may be eligible for a special payroll tax exemption.

This payroll tax benefit allows parents to exempt their children’s wages from all payroll taxes, including unemployment, FICA and Medicare. Employers who qualify for this benefit can reduce their payroll tax bill by hiring their children instead of non-relatives. S-corporations and C-corporations are not eligible for this exemption.

Of course, all income earned by the child is subject to income tax, but their income can be reduced by standard or itemized deductions that, in many cases, leads to little or no tax liability.

The standard deduction is the greater of $950 or the amount of earned income plus $300, but cannot exceed $5,800.

In 2011, this allows a child to earn their first $5,800 of wages without incurring any income tax. However, even if your child earns more than $5,800, the income will be taxed at their tax rate, which, ordinarily, is far lower than the parents’ bracket.

Tax savings realized by this income shifting can be significant. For example, suppose the net income of an optometric practice, incorporated as an S-corporation in 2011, was $250,000. Assuming that the optometrist is married and the S-corporation is his or her sole source of income, he or she will owe $59,955 in federal income tax on this profit.

However, had the optometrist hired two children at $10,000 each per year, the total practice profit would drop to $230,000. The resulting income tax bill would be reduced to $53,355.

The additional wages would incur an additional $3,060 in payroll taxes. Assuming the payroll tax holiday is not extended, and the wages are the child’s sole source of income, they would each owe about $420 in federal income taxes.

By hiring his or her children, the optometrist has realized $2,700 in tax savings.

Employing your children is also an excellent way to begin saving for their future.

Because children will have earned income, they are eligible to make contributions to a traditional or Roth IRA.

Because children are usually in very low tax brackets, a Roth IRA is generally the most advantageous.

In 2012, a child may contribute 100 percent of his or her earned income to an IRA, up to $5,000.

Contributing to an IRA can also help your child secure financial aid for college. Unlike a Coverdell Education Savings Account, the money in the IRA can be used for other purposes if your child is awarded scholarships or decides not to attend college.

Also, unlike money placed into a savings account, an IRA is not considered an asset for purposes of determining financial aid until funds are withdrawn.

Therefore, when your child applies for financial aid as a college freshman, the IRA will not be included in the financial aid calculation. However, if they take a withdrawal as a college freshman, the assets will affect the financial aid application for their sophomore year.

As an alternative, children may also take out student loans to pay their college expenses, and, upon graduation, make a withdrawal from the IRA to pay the loans off.

Employing your children can also help them build valuable life and technical skills.

Working can help children learn responsibility, time management, professionalism, and the value of hard work.

It also allows children to improve their interpersonal skills and other proficiencies that can help them in their later careers.

In order to qualify for the tax benefits, your child must be a bona fide employee of the practice. The tasks they perform must be essential to the business; that is, if your child were not performing the task, you would have to hire someone else to do it or perform the task yourself.

The tasks must be age-appropriate, and the child must be significantly equipped to complete them.

For example, a teenager with significant expertise could be paid to design the company’s website.

However, this task would not be suitable for a younger child with no knowledge of Web design. Rather, younger children could be employed to file documents, stuff envelopes, clean the office, or other tasks suitable to their knowledge and skill level.

Also, the wages paid to the child must be reasonable. In order to determine reasonableness, the IRS considers what a non-relative performing the same tasks would earn.

Treat your child just as you do other employees, and process their payroll normally. Do not pay your children in a lump sum at year end, as it could raise red flags with the IRS.

Instead, pay your children as they earn it, just as you would with non-relative employees.

In order to justify your deduction, be sure to keep records of the hours your child worked, including the tasks performed.

Provide your child with a W-2 and include their wages in your business’s quarterly payroll filings.

Finally, be sure your practice is in compliance with all applicable labor laws. Federal regulations set certain standards for child workers. Federal guidelines detail the hours children are available to work, the number of hours they can work each day, and the industries they can work in.

Generally, children employed by their parents are exempt from these laws. However, states may set more stringent requirements, so it may be prudent to consult your attorney to ensure compliance.

Although small business owners of all types can potentially realize benefits by hiring their children to work in their businesses, this strategy is often under-utilized.

Talk to your tax adviser about how hiring your children can reduce your tax bill, and start enjoying one of the benefits of parenthood.

Armstrong is a partner in the firm of May & Company, LLP. Permenter is a member of the professional staff of May & Company, LLP. The firm consults with optometrists in 30 states, assisting with their tax planning and preparation, QuickBooks support, and business planning. May & Company was established in 1922 and has offices in Louisiana, Mississippi, and Alabama. Armstrong can be reached at 601-636-4762 or by email at jarmstrong@maycpa.com.

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