You work hard for your income—so why not keep it in the family? There’s a way to do this that might be a lot simpler than you think. If you are supporting children, parents or other dependents, you can legitimately reduce your taxes by intelligently putting these individuals on your payroll.
How is this done?
When you pay a dependent, that money comes off the top of your income and shifts to someone else who will be taxed at a lower rate. This is an easy and effective method of reducing the overall taxes the household pays.
When using this strategy, there are just a few things to keep in mind:
- Anyone you hire must be at least seven years old.
- Their first $6,300 of earned income is taxed at zero. That’s because $6,300 is the standard deduction for a single taxpayer, even when you claim them as your dependent. And up to $9,225 of taxable income is taxed at just 10%. (2015 IRS Codes used here.)
- You have to pay them a “reasonable” wage for the service they perform. The tax court says a “reasonable wage” is what you’d pay a commercial vendor for the same service, with an adjustment made for the child’s age and experience.
- To audit-proof your return, write out a formal job description and keep a timesheet for all work provided.
- Pay by check, so you can document payments.
- The money must be deposited into an account in the child’s name. But it doesn’t have to be an account he has access to. It can be a Roth IRA for decades of tax-free growth. It can be a qualified college tuition plan, usually referred to as a Section 529 plan. Or it can be a custodial account that you control until they turn 21.
Let’s take a look at how these points might work out in real life.
Lower Tax Bracket
Consider a situation where an attorney makes $450,000 a year and hires his son to do simple maintenance tasks around the office—painting, keeping the grounds groomed and so on. Over a year’s time the son earns $10,000, which reduces the father’s income by the same amount. For the father, that $10,000 would have been taxed at 39.6% or $3,960. But for the son, the first $6,300 isn’t taxed and the remaining $3,700 is taxed at 10% = $370. That’s a tax saving of $3,590. What would you do with an extra $3,590? You can add this amount into his college savings account, take a short vacation, or make a few car payments.
If your 12-year-old son cuts grass for investment properties, pay him what a landscaping service might charge because there is little difference between the job a landscaper would do and the one your son delivers. If you have your child help you with data entry or filing, pay them just a bit less than a bookkeeping or clerical service might charge.
The same would apply to hiring your teenager to help with a website, posting blogs or doing social media. What would a marketing service charge for these services? It could be sizeable. In many cases, paying a reasonable wage can add up to quite a lot of money.
One thing to remember is that you don’t have to put these funds in an account your child has access to. They can go into a custodial account you keep for them. A custodial account can’t be used to cover your basic obligations of support as a parent, but it can cover many other things. Private and parochial schools, summer camps and similar items aren’t considered obligations of parental support.
Therefore, if your teenage daughter wants to spend two weeks at horse camp, you could either:
- Earn the fee yourself, pay taxes on it and pay for camp with your after-tax dollars, or
- Pay her to work in your business, deposit the check in her custodial account and then, as custodian, write the check to the camp. The ultimate effect of this transaction is to let you deduct her camp as a business expense.
If you hire your child to work in an unincorporated business, you don’t have to withhold funds for Social Security until they turn 18. So this really is tax-free money. You’ll still have to jump through some paperwork hoops, like issuing a W-2 at the end of the year and helping them file their own return if the income is enough to require them to file. But this is a small price to pay compared to the tax you’ll waste if you don’t take advantage of this strategy.
Hiring dependents provides a tax savings that may be overlooked by attorneys and other professionals, but I encourage you to consider it. When organized properly, hiring dependents is a very defensible and effective method of reducing your tax bill.
This is just one of many tax-saving strategies professionals can take advantage of. Visit a tax expert to see what else is available to you. According to the IRS, Americans overpay their taxes by $1 billion annually. A good tax strategist doesn’t just do your returns at tax time. They use their extensive knowledge of tax codes all year long to help their clients correctly structure their income and outgo.
At the end of the day, our goal is simple: to help you keep more of your hard-earned money.