If you have your own business—either full- or part-time—you have another income-splitting, tax-saving opportunity. Put your children on the payroll, working in the evenings and on weekends during the school year and during the summer. What you pay them is a business deduction for you and earned income for them. That shifts income out of your tax bracket and into the child's. Because it's earned income, the kiddie tax doesn't come into play.
Although a child can use only $850 of the standard deduction to shelter unearned income in 2006, the full deduction – $5,150 on 2006 individual returns can offset earned income. If your child's only income during the year is $2,000 earned working in the family business, for example, the child's tax bill would be zip. The $2,000 business deduction would save you $560 in income taxes if it otherwise would have been taxed in the 28% bracket.
To be deductible, the wages have to be reasonable and for real work your child performs for your business. Claiming a deduction for paying your 8-year-old $100 an hour to clean your office on Saturday mornings would be asking for a fraud charge. But paying a reasonable wage for cleaning, serving as your answering service, filing documents, making deliveries or performing other necessary services is a legitimate way to save on taxes and help build a college fund. If your child is a computer whiz, you might have no problem finding chores for him or her.
To protect your deduction, you need to handle the employment of your child in a businesslike manner. Keep careful records of the work done, the number of hours worked and the hourly wage. Pay with a check drawn on the business account. File a form W-2 reporting the earnings to the IRS.
In addition to trimming your income tax bill, putting your kids on the payroll can save you a substantial amount of Social Security tax. That tax claims 15.3% of the first $94,200 of net self-employment income in 2006. Because you get to deduct the wages you pay as a business expense, you avoid the Social Security tax on that amount. Every $1,000 of income you shift to a child via wages can save you $153 in Social Security taxes.
Assuming you operate your business as a sole proprietorship rather than a corporation, your children under age 18 are not subject to the Social Security tax. If you own rental property, consider hiring your children to mow the grass or help with other maintenance or repairs. What you pay them reduces the amount of rental income taxed in your bracket and the wages could be tax-free to the child. As noted above, earned income up to the standard deduction amount – $5,150 in 2006 – will be sheltered by the child's standard deduction.