The best kind of money is tax-free money, there is no doubt about it. Unfortunately, as you probably know, there aren’t many opportunities for you to capitalize on tax-free income. What you probably didn’t realize, is that as an independent contractor, you are able to shift a portion of your income to your children completely tax-free, something regular W-2 employees are not able to do.
When you pay your children for services they perform in your business you are creating a deduction to your business income and pushing it to your children. We are not recommending that you use your children as part of some tax sham. Which is why they need to be legitimately involved in the business, performing tasks reasonable to their age and abilities. You will need to keep a detailed record of their time, perhaps have them keep a time sheet. Your records will also have to reflect the time worked and the wages they receive.
How it works:
A sole proprietor is able to pay their children under the age of 18, wages that are not subject to social security and Medicare taxes. Additionally, thanks to the standard deduction, they don’t have to pay income tax on the first $6,300 earned, as long as you don’t pay your children over that limit.
However, if you have an S corporation, the process is slightly more complicated because you don’t receive the benefit of avoiding payroll taxes when paying your children. This benefit is strictly for sole proprietorships. So, to get around that issue, you need to setup a separate sole proprietorship, which would function as a “family management company”.
With the sole proprietorship setup, you will need to open a separate bank account for the family management company. Then this family management company receives a management fee of a little over the amount of your children’s wages, from the S corporation. Then from that fee the family management company pays your children their wages.
You have a couple options for what you can do with those wages.
If you want to use that money for expenses, you are somewhat limited in
what you can use that money for. Because your children are minors, you are in control of their money, but you can’t spend their money on things like food, clothing, or shelter for them. The IRS expects you to provide these things for your children as their parent.
This is where you have to get a little creative by identifying the things that you would normally spend money on anyway, that can be paid for with the income that has been shifted to your children. Things like vacations, summer camp, or even saving for a car when they are old enough etc. Also, if you pay your children an allowance, you can make the part of the income that they earn their allowance, effectively making their allowance a tax deductible expense.
An alternative to spending the money, is putting it into a Roth IRA in your child’s name. We say Roth IRA because any withdrawals you take from savings are treated as a “return of contribution” first and earnings second.
So if you have been contributing $5,000 each year for the last 6 years, you can withdraw $30,000 tax-free. That could be used for college, a car, or any anything else for that matter. Best of all any remaining contributions could be used to jump start your child’s retirement.
Not only does this strategy help you stash away some tax-free income, but it can also help your children understand the value of work, and even has the potential to teach them about financial planning.
Before moving forward with the strategy laid out in this article, we highly recommend talking to your CPA about the proper procedure to follow, as well as any compliance standards you need to meet.
At Independent Contractor Tax Advisors, we are tirelessly exploring new avenues to help you maximize your tax savings, by building you the most comprehensive and efficient tax strategy available to your individual situation. If you would like to know how we can save you taxes, contact us today and schedule a free tax consultation with one of our tax advisors.
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