Income Tax Savings Opportunities by Hiring Children
LISI Estate Planning Newsletter #1611 – March 2, 2010

Planning techniques for reducing income taxes have become increasingly scarce, and the likelihood of future tax increases only makes matters worse. However, one technique for saving some income taxes may be as accessible as your own family.
 
If a high income "Parent" owns a business and has a "Child" who is old enough to work but is not presently gainfully employed, then Parent's family may be able to save some income taxes without much risk or effort by employing Child in Parent's business. As Len Cason demonstrates in his commentary, this is not a "one size fits all" technique, but this one might just fit you, or one of your clients.
Len Cason is a partner in the law firm of Hartzog Conger Cason & Neville, Oklahoma City, Oklahoma.  He leads a practice group within his firm that represents affluent families across a broad spectrum of matters, including family estate and wealth transfer planning, income tax planning and tax controversies, overview of financial and investment matters, and representation of family businesses, including acquisitions and sales of businesses. 
Len is a fellow of the American College of Tax Counsel and the American College of Trusts and Estates Counsel.  He is listed in Best Lawyers of America in the areas of tax law, corporate law, and estate planning.  He is an adjunct professor of law.  He has published numerous tax and estate planning articles and is a frequent speaker on estate planning and tax topics.
 
 Here is Len's commentary:
 
EXECUTIVE SUMMARY:
 
The goal of this technique is to shift income from a high income tax bracket to a low income tax bracket.  This commentary will help LISI members navigate through the matrix of rules involved, so that they can determine whether the employment of a child is a worthwhile effort. First, we will take a brief review of the pertinent rules, and then conclude with a comprehensive example.
 
FACTS:
 
Employment Taxes. Under Federal Insurance Contribution Act ("FICA"), an employer must withhold from an employee's wages 6.2% for old age, survivors, and disability insurance ("OASDI") taxes (subject to a cap of $106,800 in 2010) and 1.45% for Medicare taxes for a combined FICA tax rate of 7.65%. 
 
Then, the employer must also match the 7.65% FICA taxes withheld for a total of 15.3% in FICA taxes. In addition, the Federal Unemployment Tax Act ("FUTA") requires the employer to pay FUTA taxes of 6% on the first $7,000 of an employee's wages each year. 
 
The FICA and FUTA taxes paid by the employer are deductible by the employer as a business expense. The FICA taxes withheld from the employee are nondeductible by either the employer or the employee.
 
Contributions to the Child's Retirement
 
For year 2010, Child can make a tax deductible contribution of up to $5,000 to a traditional IRA out of Child's wages, or Child can make a nondeductible contribution of up to $5,000 to a Roth IRA.
 
Importance of Child Not Qualifying as Dependent of Parent
 
Ironically, it is critical for purposes of using this technique that Child DOES NOT qualify as a "dependent" of Parent. If Child does not qualify as a dependent of Parent, then:
 
(i)      Child will be eligible to take a personal exemption deduction on Child's own income tax return.  See "Personal Exemption Deduction", below.
                                                                                               
(ii)      Child will be eligible to take the full standard deduction on Child's own income tax return. See "Standard Deduction", below.
                                                                                               
(iii)     Child will be eligible for the American Opportunity Credit for college tuition. See "American Opportunity Credit", below.
                                                                                        
Child can avoid being a dependent if any one of the following three tests can be met:
                                                                                        
·        First, Child is over age 18 by the end of the calendar year and is not a full-time student, or if a full-time student, is over age 23.
 
·        Second, Child does not have the same principal residence as Parent for more than half of the year.
 
·        Third, Child provides more than half of his or her own support for the year. 
 
Personal Exemption Deductions
 
For 2010, the personal exemption is $3,650 per person.  Child will not be able to take a personal exemption deduction on Child's own income tax return if Child could be claimed as a dependent by Parent.   The catch-22 of this regime is that the ability of a high income taxpayer such as Parent to actually deduct personal exemptions may be limited or even eliminated in the future.
 
For tax years through 2009, the ability of high income taxpayers to deduct their personal exemptions was phased out on a graduated basis. For 2009, the phaseout for a couple filing a joint return started at $250,200 of AGI.
 
For year 2010, the phaseout has been repealed.  However, beginning in year 2011, the phaseout is scheduled to return.  Further, certain lawmakers have proposed making the personal exemption deduction ever more limited to high income taxpayers.
 
Standard Deduction
 
Taxpayers who do not itemize are entitled to a standard deduction. Child may be entitled to a standard deduction of $5,700 in year 2010, unless Child qualifies as a dependent of Parent.
 
Education Tax Credit
 
The American Opportunity Credit, which allows a dollar-for-dollar credit on the first $2,000 of qualified education expenses plus 25% of the next $2,000 of qualified education expenses, for a total possible credit of $2,500 per year for four academic years. Qualified education expenses include tuition, fees, and course materials. There is a phaseout of this credit for high income taxpayers, but so long as Child has "modified AGI" of under $80,000 to $90,000, then Child can claim the full credit on Child's own tax return.
 
The "Kiddie" Tax
 
Under the "kiddie tax" rules, "unearned income" of certain children is taxed at Parent's marginal income tax rate rather than at Child's usually lower income tax rate. To avoid the kiddie tax, Child must be age 18 or older and not a full-time student, or if Child is a full-time student, must either be age 18 and have earned income equal to more than half of Child's total support or be age 24. 
 
Validating the Employment
 
The employment arrangement between Parent and Child must have economic substance. There should be a written employment agreement which sets forth the terms of employment. Then, actual services should be performed, and the performance of those services should be memorialized in some way.
 
A Comprehensive Example
 
Let's put all of these pieces together in an example:
                                                                                        
·        Parent owns a business and is in the 35% federal and 5% state income tax brackets. 
·        Child has $20,000 of unearned income, consisting of $10,000 of qualified dividends and $10,000 of interest income attributable to transfers of property which Parent has made to Child through the years.
·        Parent employs Child in the business and pays Child $30,000 of annual wages. 
·        Child is age 23 and is a full-time student with over $4,000 of tuition.  Child's total support for the year is $59,000. 
·        Child actually pays for $30,000 (over half) of Child's support. Child is not a dependent of Parent, because Child provides more than half of Child's support for the year.
·        Child is not subject to the kiddie tax, because Child's earned income of $30,000 exceeds half of Child's support for the year.
·        Child is not married, and thus has one personal exemption deduction and one standard deduction.
·        Child contributes $5,000 to a traditional IRA. 
 
Analysis 1, below, illustrates the after tax family cash flow if Child were not employed by Parent. Analysis 2 illustrates the after tax family cash flow if Child is employed by Parent.
 
1.             Assume Child is Not Employed by Parent:                                                Parent
               
          Income retained by Parent and not used to compensate Child                        $30,000
                Interest income of Child (subject to kiddie tax)                                          10,000
                Qualified dividend income of Child (subject to kiddie tax)                        10,000           
                Income tax                                                                                                  (18,000)
                Family cash flow                                                                                        $32,000
               
40% combined tax rate times $30,000 retained income and $10,000 interest income plus 20% combined tax rate times $10,000 qualified dividend income. FICA and FUTA taxes are deductible by Parent and thus the tax burden is reduced by 40%
 
2.             Assume Child is Employed by Parent:                                                                   Child                                    
                                Interest income                                                                                         $10,000
                                Qualified dividends                                                                                   10,000
                                Wages                                                                                                         30,000
                                Personal exemption                                                                                    (3,650)
                                Standard deduction                                                                                     (5,700)
                                IRA                                                                                                             (5,000)
                                Tentative income taxes                                                                               3,430
                                Less AOC tax credit                                                                                   (2,500)
                                Child's taxes                                                                                                 $930
 
  
Assuming Child is employed by Parent, here is how after tax family cash flow is affected:
 
                                                                                                                     Child                  Parent
                                Income                                                                      $50,000                   
                                Less Child's income taxes                                              (930)                     
                                Less FICA taxes                                                         (2,295)              (2,295)
                                FICA tax benefit                                                                                        918
                                Less FUTA taxes                                                                                     (420)
                                FUTA tax benefit                                                    ______                      168
                                Cash flow                                                               $46,776                  (1,629)
                                Parent's  cashflow                                                     (1,629)                                                                                                                                    
                                Family net cash flow                                                 45,147  
                                Cash flow if child not employed                             (32,000)      
                                Overall family savings                                            $13,147
                                                                     
FICA and FUTA taxes are deductible by Parent and thus the tax burden is reduced by 40%
 

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