Income shifting is the technique of turning higher-taxed income of parents into lower-taxed income of children.
A business owner can use the strategy of employing their child to accomplish this shift. In 2013, the standard deduction will be $6,100 for individual taxpayers. A dependent child can earn this amount before being subject to federal income tax. This can potentially reduce the income passed along to the parent.
Depending on the tax rate, federal income tax savings could be up to $2,415.60 for a parent in the 39.6 percent bracket. If earnings are higher than $6,100, additional taxes are saved by being taxed at the child’s lower marginal rate of 10 percent for the first $8,925 of additional income vs. the marginal rate of the parent.
A parent in the 39.6 percent bracket pays $39.60 for each $100 of additional income, where a child in the 10 percent bracket pays only $10 for each $100 of additional income. The work needs to be legitimate and the child has to be paid a reasonable salary for the type of labor performed.
For the state of Illinois, the savings are not as straight forward.
A dependent child can earn up to $2,050 before being taxed. There would be a $102.50 savings for employing the child rather than having this income pass through to the parent. If the dependent child earns more than $2,050, the child will not be allowed an exemption. Illinois will tax the entire amount the child earns at 5 percent, the same rate the parent would be taxed at.
Favorable payroll tax rules may also apply. If a child is employed by a parent in an unincorporated business, a child under the age of 18 is exempt from FICA taxes and a child under age 21 is exempt from FUTA taxes.
Depending on the type of retirement plan the business has and eligibility requirements, the child may be eligible for retirement benefits. An additional savings strategy is the child making after tax contributions to a Roth IRA account. There is a tremendous advantage of starting at a young age, and letting the income grow tax free in this type of after-tax account.
Another benefit is that compensation received for personal services performed is not subject to the "kiddie tax" rules.
When a child has interest, dividend, and other investment income, the child might be subject to a “kiddie tax.” This tax is for children who have investment income in excess of $2,000 for 2013. Essentially, amounts in excess of this are taxed at the parents’ higher marginal tax rates.
A child may be subject to the “kiddie tax,” in 2013 if investment income is greater than $2,000 ($1,900 for 2012) and any of the following are true:
1. The child is either under the age of 18 at the end of the tax year
2. The child is 18 and earned income is less than 50 percent of amounts spent for the child’s food, lodging, clothing, education, medical care, recreation, transportation and similar necessities
3. The child is age 19-23, a full time student, and earned income is less than 50 percent of amounts spent for support as noted above.
The rules do not apply if the child is married and files a joint return or if he or she does not have at least one living parent at the end of the year.
The basics of the “kiddie tax” are that a child’s investment income is reduced by a $1,000 standard deduction. Remaining income up to $1,000 is taxed at the child’s marginal rate with any in excess taxed at the parent’s marginal tax rate.
The “kiddie tax” rules make it difficult to transfer investment income to children, but slight savings can still be achieved on the first $2,000 of income transferred.
It is also important to note that the parent must transfer ownership of the asset generating the income. A parent cannot assign only the interest or dividends on an account to a child. The ownership of the account needs to be transferred to the child. Consult your tax advisor for how these strategies would apply to your individual tax situation.
• Michael J. Flood, CPA, MST is a Partner with Caufield & Flood in Crystal Lake. He can be reached at 815-455-9538, Michaelf@cfcpas.com or through the website CFCPAS.com.