Children Can be Good Tax Planning Tools

Whether trying to fund college for your child or just general tax planning, a parent in business has an extra opportunity to save some big taxes while teaching their child(ren) some work ethics. Consider Internal Revenue Code Sec. 3121(b)(3)(A). In summation, a mother or father may pay their child a “reasonable” sum for working in the parent’s self-employed business (not an incorporated entity) and, if the child is under 18 years, there is no payroll tax (defined basically as Social Security and Medicare taxes) on these wages.

Further, the additional planning opportunity is based on the fact the payment to the child is “earned income” to the child, which means the child gets a $12,400 U.S. standard deduction (in 2020). This means the first $12,400 paid to the child is free of all income taxes. The fact that the parent and child do not pay the payroll taxes the family has shielded an extra $12,400 from taxation, per eligible child. If a self-employed parent is in the 22% federal income tax bracket, coupled with the 15.3% of payroll taxes normally required on wages, there is about a 37% tax savings on these wages paid to your child, as this amount of wages is fully deductible to the parent’s business.

And with many people being home with their children during the COVID-19 pandemic, this would seem like a good a time as any to train and monitor your child in a viable business environment.

So, have your child save this money for their college fund, etc. This money does not need to be put in a 529 plan to be shielded from taxation; so, it is available, without penalty, should the child need it for school or otherwise, at a later date.

Note, the payment to the child must be for legitimate work relating to the business which could be filing, (manual or computer), schedule maintenance of business clientele and other mundane business chores. The work must also be age appropriate. Also consider, if your business needs to advertise, then the use of the child’s likeness would also qualify if within the legitimate scope of the business.

You may also use the money paid to your child to establish an IRA account on their behalf, which is a great way to help your child focus on the future and get a head start on lifetime financial planning. For 2020, the IRA for a child would be $6,000 which, if applicable, could raise the deductible amount you pay your child to $18,400. Or, if a state like NY, which has a much lower standard deduction for a child ($3,100 for 2020), you would then shield $9,100 from taxation in New York.

And lastly, presuming the parent is still providing over half the support for their child all the tax exemptions and tax credits are still fully available to the parent.

Choice of Entity

When starting a business there is the choice of entity to use for your business. The basic choices are:

1. Sole Proprietorship (a one-person entity that requires minimal government filings to form)

2. Partnership (two or more people or entities operating a business; requires some business filing-usually at the local government level)

3. Limited Liability Company or Limited Liability Partnership (could be a sole person or two or more people or entities operating a business; requires formal filing usually at the State level)

4. Corporation, as a “C” or “S” corporation (could be a sole person or two or more people or entities operating a business; requires formal filing usually, also, at the State level)

The below graph shows the general tax aspects and limitation on personal liability of each entity:

Entity Type	Self employment tax	Income tax	Limited liability
Sole Proprietorship	Yes (a)	Personal Rates	No
Partnership	Yes (a)	Personal Rates	No
Limited Liability Company	(b)	(c)	Yes
"C" Corporation	No	Corporate Rates	Yes
"S" Corporation	No (d)	Personal Rates	Yes

(a)   Generally, each owner(s) must pay a tax of 15.3% up to the Social Security wage base for any particular year. This is over and above personal income tax rates.

(b)   Subject to Self employment tax if the owner(s) fail(s) to make a tax election which then taxes the owner as an individual (if one person owns the LLC) or taxes the owners as a Partnership.

(c)   Personal income tax rates, if the owner(s) fail(s) to make a tax election. If one elects to be treated as a "C" corporation then entity is subject to corporate income tax rates.

(d)   Internal Revenue Service regulations do require reasonable wages be paid to corporate officers, which subjects these wages, only, to the 15.3% tax.

The above represents a general view of your choices. Some exceptions for the above taxation and some other attributes of the above entities are:

1. A Sole Proprietorship that conducts rental property activity only will not be subject to the Self employment tax (even presuming it reflects a positive income on such rental activity).

2. A Partnership can technically form as a Limited Partnership or have Limited Partners. A limited partner will NOT be subject to Self employment tax (but is subject to personal income tax). It is possible to be a limited partner one year but not in other years, which is dependent on how active the partner is in conducting Partnership business.

3. A Limited Liability Company (LLC) may be owned by one of more persons or entities. If owned by only one entity it is classified as a Disregarded Entity, which means the sole owner reports the income activity on their personal tax returns and thus does not have to file a separate (LLC) return. If there are two or more owners of an LLC then the LLC must file a Partnership return, unless it has made a tax election to file as a Corporation (“C” or “S” are both permitted elections).

4. A “C” corporation is subject to corporate tax rates but could also lead to double taxation. If this corporation pays its earnings out via dividends then the corporation receives no deduction for paying these dividends but any individual receiving this dividend is taxed on this money, hence the double taxation. Therefore, it is often advisable to compensate owners with reasonable wages because these wages are deductible to the corporation so the wage taxation to the individual owner would not represent double taxation.

5. An “S” corporation passes through its income to the shareholders. Alternatively, any losses on “S” corporations, generally, can flow through to these owners to reduce their personal taxes. In comparison, a “C” corporation that losses money can only carry the losses to future years of the “C” corporation.

Forfeited Tax Refunds

There’s nothing worse when a taxpayer unintentionally forfeits their tax refund. Many are unaware that the U.S. tax law has a statute of limitations for someone to claim their tax refund. Forfeiture usually happens unintentionally because taxpayers file their returns late, after the statute of limitations.

The Internal Revenue Code forfeiture statutes are codified in section 6511 of the Internal Revenue Code, and any regulations the IRS has written to clarify these rules. The general rule is a taxpayer must claim the refund for their return within three years of the due date of the return, or two years after payment of the tax.

The three-year period of the due date means that you must file and claim the refund within three years of the original due date, or the extended date (in the event you file an extension).

EXAMPLE 1:

For the 2018 tax year, you file on the due date of April 15, 2019. In this case, you must make a refund claim by April 15, 2022.

EXAMPLE 2:

For the 2018 tax year, you file an extension for October 15, 2019 - you also file your return on the extended due date of October 15, 2019. In this case, you have three years after the extended due date, or October 22, 2022, to claim a refund.

EXAMPLE 3:

For the 2018 tax year, you file an extension for October 15, 2019 - however, you also file your return on the prior to the extended due date of October 15, 2019, filing your return on September 10, 2019. Since the IRS has received your return on September 10, 2019, the three-year period to claim a refund begins on this date. Therefore, you must claim a refund on or prior to September 10, 2022.

EXAMPLE 4:

For the 2018 tax year, you file on April 1, 2019, before the due date of April 15, 2019. In this case, you must make a refund claim by April 15, 2022, three years after the original due date. In this example, let’s say the IRS audits your return on October 1, 2021 and makes additional assessments against you, which you pay on November 1, 2021. If you later realize the IRS has made a mistake on their additional assessment, you have until two years (i.e. November 1, 2023) after the payment date to make a claim for a refund, although November 1, 2023 is after April 15, 2022.

Unless you can prove severe mental or physical disability (under Code section 6511(h)(2)), the three-year limit would apply and you will be denied your applicable refund. Code section 6511(h)(2) keeps the time to claim a refund open, but the taxpayer has a tough burden of proof under this section of the Code.

You may wonder why taxpayers unintentionally forfeit their refunds, which happens more often than you would think. In most cases, it’s due to non-filing until three years after the due date of the original return. In any case, we urge you to always file your taxes timely to avoid forfeiture of a refund, if you’re owed one. And remember, it is the taxpayer’s burden to prove timely filing of their claim for a refund. This is accomplished by an e-file receipt or courier tracking receipt.

THE MANY FACETS OF THE IRS STATUTE OF LIMITATIONS

The obligation to accurately report income taxes to the Internal Revenue Service is squarely on the shoulders of the taxpayer. However, the term “accurate” is the essential element here.

Consider taxpayers who have their own businesses, whether a Sole Proprietorship (Schedule C), flow thru entities such as Partnerships or S Corporations, or C Corporations. The mere declaration on these business returns of merely reporting the correct net income (bottom line) is not sufficient. The Internal Revenue Code has many statutes regarding the “Statute of Limitations” which quite simply means the time that IRS must select your return for audit, and thus attempt to make additional tax assessments against the taxpayer. This tax Code section 6501 has many parts to it.

The general rule, per the Code is the three year time frame for the IRS to audit and assess. This three year period is three years from the later of the original due date (usually April 15th) or later if the return is filed after April 15th , such as returns on extension or late filed returns. However, there are many twists an nuances to the Code section. One exception is failing to file a return or filing a “false” return. In these cases, the IRS has no time limit to audit and assess. Failing to file is a simple concept which means a taxpayer never files a return that is otherwise required to be filed.

A “false” return means substantial incorrect figures, which basically encompasses tax evasion. Mere over estimates of deductions, by estimating certain expenses, within a reasonable degree, for which the taxpayer has a reasonable basis, is not usually a basis to keep the statute open ended.

Another area that could extend, but not indefinitely extend, is under reporting gross business income by more than 25%. So, should a taxpayer not have exact figures on the net business income the taxpayer is advised not to merely estimate the net income but rather is advised to gross up sales and then list each type of expense. As an example, if a business return estimates the gross income/sales as $100,000 and expenses of $20,000 producing a net income of $80,000 but if IRS examines this return and finds that the summation of this net income is actually gross sales of $130,000 (with possible expenses of $50,000 (which still produces the same net income of $80,000)) IRS may invoke sub section 6501(e) under the Code. This is because the “gross income” or “gross sales” were under-reported by 30% ($30k not reported divided by $100k of sales reported). So, even if, at first glance, there may not be any change to the “bottom line” you are stuck with this examination and after almost six years it is much tougher to recall and compile receipts to support your expenses, much more than it would have been only after a three year period.

So, when filing your returns, each aspect of the return must be properly reported.

Federal Corporate Tax Rate 2018-2025

The Tax Cuts and Jobs Act of 2017 (the “Act”) lowered the federal corporate tax rate to 21%.

1. The Act reduced the “C” corporation tax rate from 35% to 21%. Many think this tax break is solely meant for America’s largest corporations-which is not so. But, before a small business jumps onto the “C” corporation “band wagon” consider the following: Are you willing to leave profits in the corporation indefinitely?

1. Remember, in comparison, an “S” corporation has very lax rules as to distributing funds. These shareholders may usually simply take residual cash/profits without any tax consequences. But a “C” corporation has stringent rules. Taking residual cash/profits from the “C” corporation can create DOUBLE taxation. This is because the entity structure does not allow for tax free distributions like an “S” corporation. If the “C” corporation shareholder pays him/herself residual cash/profits there is generally no corresponding deduction to the “C” corporation (so you have not reduced the “C” corporation tax at all) but you likely will be fully taxed, individually, upon you personally receiving this distribution, as a dividend, usually.

1. Many times, the tax on this distribution will be at ordinary individual tax rates but with some careful tax planning the tax on these distributions (dividends) can be taxed at individual capital gains rates (from 0% to 20%, albeit most people are in the 15% capital gains bracket). Presuming you have structured this distribution at the 15% capital gains bracket you have effectively, as a small business person, paid a 36% tax on these distributions (21% at the corporate level since there is no deduction to the “C” corporation, plus the 15% personal tax rate you pay as an individual). And if this distribution is not structured under capital gain rates you could easily pay a 22% (the rate many Americans will hover around, personally) personal tax plus the 21% corporate tax, yielding a 43% total tax on these distributions.

1. Thus, any time funds are paid out of a “C” corporation you should try and be sure there is a corresponding deduction at the “C” corporation level. Paying out bonuses to the owners triggers personal taxes to the recipient, at that person’s individual tax rate but also allows for a deduction at the corporate level. Shareholders may also pay out rents to themselves if the owners use their property for the corporation’s business-again taxable income to the individual and a tax deduction to the Corporation. The key here is to try and balance the competing tax rates. So careful planning is required to try and stay within the personal tax bracket of 22% (up to $82,500 for single persons and $165,000 for a married couple). Once you exceed these personal limits it does not make sense to have more income individually as the corporate deduction is only 21%.