It’s Not Child’s Play – Tax Benefits of Hiring Your Children to Work in Your Practice

Although the unemployment figures have improved, it can still be difficult in the current job market for some college students and recent graduates to find seasonal or permanent jobs. Your medical practice may be the only place for some kids to find work or to find their first job, including your own children.

 As this article explains, employing a child of a practice owner may generate tax savings.

Regardless of how a practice is organized, its owners may be able to turn some of their high-taxed income into tax-free or low-taxed income by employing their children. The work done by the children must be legitimate, and the amount that the practice pays them must be reasonable for the wages to be deductible.

Here’s an example. A physician in the 33{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} tax bracket for 2015 hires her 17-year-old son to help with office work full-time during the summer and part-time into the fall. He earns $6,300 during the year (and doesn’t have earnings from other sources). By hiring him and making this payment to him, the physician saves $2,079 (33{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of $6,300) in income taxes at no income-tax cost to the son, who can use his $6,300 standard deduction for 2015 to completely shelter his earnings.

Family taxes are cut even if the child’s earnings exceed his or her standard deduction. That’s because the unsheltered earnings will be taxed to the child beginning at a rate of 10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}, instead of being taxed at the parent’s higher rate.

The so-called ‘kiddie tax’ taxes unearned income of certain children as if it were the income of their parents. It applies to a child if he or she does not file a joint return for the tax year and (1) hasn’t reached age 18 before the close of the tax year or, (2) the earned income doesn’t exceed one-half of his or her support and the child is age 18 or a full-time student age 19-23.

Thus, employing a child age 18 or a full-time student age 19-23 could cause his or her earned income to exceed more than half of his or her support. This, in turn, could help to avoid the kiddie tax on the child’s unearned income.

Additional savings are possible if the child is paid more (or works part-time past the summer), and deposits the extra earnings into a traditional IRA. For 2015, the child can make a tax-deductible contribution of up to $5,500 to his or her own IRA.

The business also may be able to provide the child with retirement-plan benefits, depending on the type of plan it uses and its terms, the child’s age, and the number of hours worked.

Thus, between the child’s standard deduction and IRA contribution, a child can earn up to $11,800 in 2015 without paying any income taxes.

Additional intra-family tax savings in the form of education credits may be available.

For 2015, taxpayers may claim an American Opportunity tax credit (AOTC) equal to 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of up to $2,000 of qualified higher-education tuition and related expenses plus 25{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. Thus, the maximum AOTC is $2,500 per year for each eligible student. For 2015, the availability of the credit phases out ratably for taxpayers with modified AGI of $80,000 to $90,000 ($160,000 to $180,000 for joint filers).

Taxpayers may elect a Lifetime Learning credit equal to 20{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit for any taxpayer for a tax year is $2,000, regardless of the number of students for whom he has paid qualified amounts.  For 2015, the credit is phased out ratably for taxpayers with modified AGI from $55,000 to $65,000 ($110,000 to $130,000 for marrieds filing jointly).

Where a parent pays the college-education expenses of a child whom he claims as a dependent, only the parent may claim the education credits (if otherwise eligible). However, if a parent is eligible to but does not claim a student as a dependent, the student may claim the education credit for qualified expenses paid by him or the parent.

It may actually pay for a parent not to claim the student as a dependent if (1) the parent can’t claim education credits because of high modified AGI, and (2) the student pays, or is deemed to pay under  the expense, and has sufficient tax liability (e.g., from summer or part-time employment) to claim the credit.

As an example, a married couple has AGI of $250,000 and is in the 33{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} bracket. For 2015, claiming their 19-year-old college-freshman son as a dependent would save $1,320 in taxes (33{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of $4,000 dependency exemption for the son). The parents spend $24,000 on the son’s AOTC-eligible qualified tuition. The son has $15,000 of taxable income from his salary working for the practice and has no other earned income. The parents can’t claim an education credit for their child because of their high income and would be better off not claiming their son as a dependent.

If they don’t claim the son as a dependent, the son may use the education credit to completely eliminate his $1,788.75 tax liability (10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of $9,225 taxable income, plus 15{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of the $5,775 balance).

If a parent is eligible to claim a child as a dependent but doesn’t claim him, the child still cannot claim an exemption for himself.

The case for not claiming the child as a dependent would be even more compelling if the parent’s personal exemptions would be reduced by the personal-exemption phaseout. For 2015, for example, the exemption phaseout for joint filers and surviving spouses begins at $309,900 of AGI and ends at $434,400 of AGI.

Unless the child is under age 18 and employed by the parent in an unincorporated entity, such as a sole proprietorship, the child’s earning will be subject to Social Security and Medicare taxes. Assuming the parent has already exceeded the Social Security wage maximum of $118,500, shifting wages to the child will result in additional Social Security tax (employee and employer, net of deduction for employer portion) of about 10.4{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}.

To determine how these rules apply to your particular situation, you should consult your tax adviser. Also keep in mind that some of the rules about employing children (such as the maximum amount they can earn tax-free) change from year to year, and may require your income-shifting strategy to change as well.