As a business owner, you should be aware that you can save family income and payroll taxes by putting junior family members on the payroll. You may be able to turn high-taxed income into tax-free or low-taxed income, achieve social security tax savings (depending on how your business is organized), and even make retirement plan contributions for your child.

In addition, employing a child age 18 (or if a full-time student, age 19-23) may be a way to save taxes on the child’s unearned income, as explained below.

Here are the key considerations:

Turning high-taxed income into tax-free or low-taxed income. You can turn some of your high-taxed income into tax-free or low-taxed income by shifting some of your business earnings to a child as wages for services performed by him or her. In order for your business to deduct the wages as a business expense, the work done by the child must be legitimate and the child’s salary must be reasonable.

For example, suppose a business owner operating as a sole proprietor is in the 39.6% tax bracket. He hires his 17-year-old daughter to help with office work full-time during the summer and part-time into the fall. She earns $6,100 during the year (and doesn’t have any other earnings).

The business owner saves $2,415.60 (39.6% of $6,100) in income taxes at no tax cost to his daughter, who can use her $6,200 standard deduction (for 2014) to completely shelter her earnings. The business owner could save an additional $2,178 in taxes if he could keep his daughter on the payroll longer and pay her an additional $5,500. She could shelter the additional income from tax by making a tax-deductible contribution to her own IRA.

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

Keep in mind that bracket-shifting works even for a child who is subject to the kiddie tax, which causes the child’s investment income in excess of $2,000 for 2014 to be taxed at the parent’s marginal rate. The kiddie tax has no impact on the child’s wages and other earned income.

The kiddie tax doesn’t apply to a child who is age 18 or a full-time student age 19 through 23, if the child’s earned income for the year exceeds one-half of his or her support. Thus, employing a child age 18 or a full-time student age 19-23 could also help to avoid the kiddie tax on his or her unearned income.

For children under age 18, there is no earned income escape hatch from the kiddie tax. But in all cases, earned income can be sheltered by the child’s standard and other deductions, as noted above, and earnings in excess of allowable deductions will be taxed at the child’s low rates.

What about income tax withholding? Your business probably will have to withhold federal income taxes on your child’s wages. Usually, an employee can claim exempt status if he or she had no federal income tax liability for last year, and expects to have none for this year. However, exemption from withholding can’t be claimed if (1) the employee’s income exceeds $1,000 for 2014, and includes more than $350 of unearned income (such as dividends) for 2014, and (2) the employee can be claimed as a dependent on someone else’s return. Keep in mind that your child probably will get a refund for part or all of the withheld tax when he or she files a return for the year.

Social security tax savings, too. If your business isn’t incorporated, you can also save some self-employment (i.e., social security) tax dollars by shifting some of your earnings to a child. That’s because services performed by a child under the age of 18 while employed by a parent isn’t considered employment for FICA tax purposes.

For example, let’s say a sole proprietor who usually takes $120,000 of earnings from the business pays $5,700 to her 17-year-old child. The sole proprietor’s self-employment income would be reduced by $5,700, saving her $165.30 (the 2.9% HI portion of the self-employment tax she would have paid on the $5,700 shifted to her daughter). This doesn’t take into account a sole proprietor’s income tax deduction for one-half of his or her own social security taxes.

A similar but more liberal exemption applies for FUTA (unemployment) tax, which exempts earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents.

Note that there is no FICA or FUTA exemption for employing a child if your business is incorporated or a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work you’d pay someone else to do, anyway.

Retirement benefits. Your business also may be able to provide your child with retirement benefits, depending on the type of plan it has and how it defines qualifying employees. For example, if it has a simplified employee pension (SEP), a contribution can be made for the child up to 25% of his or her earnings but the contribution cannot exceed $52,000 for 2014. The child’s participation in the SEP won’t prevent the child from making tax-deductible IRA contributions as long as adjusted gross income (computed in a special way) is below the level at which deductions for IRA contributions begin to be disallowed. For 2014, that figure is $60,000 for a single individual.

If you have any questions about how these rules apply to your particular situation, please don’t hesitate to call. 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, too.

The home price declined sharply in recent years, after the biggest real estate bubble had burst and many home owners lost equity in their homes. The real estate market, especially in California, may take longer than other states to recover its peak value equal to 2006.  However, with low home prices and interest rates, owning real estate is potentially a good investment and a great tax saving tool, depending on your income level.  Most of the people are familiar with tax advantages of selling a principal residence. The IRS code, Section 121 provides the exclusion amount of up to $500,000 (for married filing joint) of gain from the sale of a residential property if the property was used as a principal residence for at least 2 out of 5 years.  Also, the interests and property taxes paid are tax deductible.  However in this column, the focus will be on the sale of rental properties, which is more complicated and unfamiliar then the sale of a principal residence.

Rental property held for more than a year and sold for a gain:

If you had a rental property for more than a year and sold it at a gain, then your gain would be taxed at two different tax rates. Your gain will be taxed, first, at an ordinary income tax rate up to 25% to recapture your depreciation expense that you have taken out over the years and the rest would be taxed at a lower long term capital gains tax rate.  Let’s say that you purchased your rental home 10 years ago for $200,000 and have taken out a depreciation expense of a total of $50,000, then your basis in your property is $150,000 ($200,000 – $50,000). If you sold this property for $250,000, then your total gain would be $100,000 ($250,000 – $150,000). Out of the $100,000 gain, the first $50,000 would be taxed at an ordinary tax rate up to 25% and the other $50,000 would be taxed at 15% long term capital gains rate.

Rental property held for more than a year but sold for a loss:

Don’t feel too badly if you sold your rental property at a loss, which is not so uncommon now days.  If you had your rental property for more than a year and sold it at a loss, then unlike capital loss which only allows a $3,000 deduction against your ordinary income, you could offset your entire loss against your ordinary income which would lower your tax liabilities and possibly get you more refund. But here is the best part of it, you could carry back your loss for two years and get the refunds for those two years that you paid taxes if your loss is big enough to wipe out the current income to zero.  After you reduce your current income to zero and carry your loss back for 2 years and still have a loss from the sale of the rental property, then you can carry forward your loss for up to 20 years which will reduce your future taxable income.  Nobody wants to sell their rental properties at a loss, but if it does happen (which is quite common now days), please talk to your CPA to find the great tax saving advantages from it.

Principal residence turned into rental property and sold it at a loss:

This current bubble created the biggest loss of equity in homes nationwide and California is the worse compared to other states.  Many home owners try to sell their principal residences for a long time, and then finally give up selling it.   Instead, they decide to rent it and wonder if they could deduct the loss if they finally sold their rental properties below the purchase price of their principal homes.  Generally, a loss from the sale of a principal home is not tax deductible, but once it is converted to a rental property and the value declines further after the conversion to a rental property, then the loss could be deductible when the property is sold.  For example, if you purchased your principal residence at $600,000 in 2005, but you decided to convert it to a rental property in 2009 after several failed attempts to sell it.  The basis for your rental property is the lower of the costs or the fair market value at the time of conversion, so, if the market value has declined to $250,000, then your basis is $250,000 (not $600,000).  Assume you have taken out $20,000 of depreciation expenses from 2009 ~2011 and sold your home for $200,000, then your loss is $30,000 ($250,000 – $200,000 – $20,000).

Rental property turned into principal residence and sold it at a gain:

This is the mirror image of the example above.  If you have a large appreciation in your rental home, then there is a great tax advantage for converting it to your principal residence and then sell it because of $500,000 exclusion explained above. But, there are conditions and limitations that must be carefully considered.  As I explained above, the depreciation expenses that you have taken out throughout previous years must be recaptured as an ordinary income which would be taxed at a maximum 25%.  The rest of the gains would be treated as a long term capital gains but, up to $500,000 (for married filing joint) would be exempt under Section 121 of the IRS code if the property was used as principal residence for at least 5 years or may have to allocate the gains between qualified use and nonqualified use. The nonqualified use portion of the gain would be not excluded under Section 121.

Conclusion:

In general, if you have a rental property, you should consult with your CPA.  As the examples above show, the plan you make for that property can be beneficial to you or detrimental to you.  Please remember, that every year you could deduct up to $25,000 of loss from your rental activities against your ordinary income, if your income is below a certain threshold.  If you are making above that threshold, then you are not allow to deduct that loss against your ordinary income, but carry it forward to the next year until you have a positive rental income.  The rental loss could be accumulated and may not help you lower your overall income tax liability now, but you can free up this loss when you sell this rental property in the future.

If you have questions, need additional information or would like to discuss more on the above topic, please feel free to call us and/or visit our office.