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If you operate your business as a sole proprietorship, a single-member LLC (treated as a sole proprietorship for tax purposes), or a husband-wife partnership, here’s a great family tax planning deal: Hire your under-age-18 children as legitimate employees of the business. It doesn’t matter if they work part-time or full-time. Why does hiring he kids makes sense? When your kids become teenagers, they can set aside some or all of the wages earned and invest the money. The investment earnings and gains will be taxed at low rates. Later, your child’s savings can be used to help pay for college, which means you won’t have to come up with quite as much cash.
So far so good, but here are some more advantages:
Your child’s wages are exempt from Social Security, Medicare, and federal unemployment taxes. Even better, your child can use his or her standard deduction to shelter up to $5,950 in wages from federal income taxes in 2012. So your child may owe absolutely no federal taxes under this arrangement.
Your side of the equation is also excellent. First, you get a Schedule C business deduction (Schedule E if you run a husband-wife partnership) for money you might have just handed over to your child anyway. The write-off reduces both your federal income and self-employment taxes. Your adjusted gross income is lowered too. That means less chance of all those unfavorable phaseout rules biting you in the pocketbook.
After your child reaches 18, things are not quite so great. The Social Security and Medicare taxes kick in. As the employer, you’ll pay half and the other half will be withheld from your child’s wages. Just make sure you pay wages that are reasonable for the work performed. Keep the same records as you would for any other employee to substantiate hours worked by your child. And don’t forget to issue a Form W-2 early next year.