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.