By Adam Cmejla, CFP®
March 21, 2018
Many practices employ family members, including students. It can seem like an ideal arrangement, providing your own children with an after-school job and a preview of the work you do. In addition to providing a great opportunity for a son and daughter to see if they want to follow you into optometry, there are both financial benefits, and potential difficulties, to employing a child. Here’s how to maximize the benefits, while guarding against the possible problems. As with all tax-related strategies, it’s always a good idea to involve a qualified tax advisor or CPA in your conversations.
Let’s look at a hypothetical example of a practice owner’s personal income, and we’ll use round numbers to make the math easy. Let’s say that our OD is married with two children, ages 13 and 16. His wife does not work outside the home (nor is she employed in the practice). He is the sole OD in the practice that he started 20 years ago, and total gross receipts collected is about $700,000 per year. His practice is structured as a single-member LLC, and he elects for S-Corp taxation on his business. He runs an efficient practice with a 28.5 percent profit margin, meaning his total net business income (before taxes) is approximately $200,000. He splits that $200,000 up by paying himself a W-2 salary equal to the Social Security wage base of $128,400, and takes the rest ($71,600) home as pass-through business income.
The calculation of the net amount that is taxed on the above illustration is beyond the scope of this article, and does not need to be illustrated to make the point of how employing your children can have significant benefits. Let’s look at what happens if his two kids are employed in the practice on a part-time basis.
The Benefits: Paying the Kids
As long as both kids are under the age of 18, subject to a few exceptions, you won’t have to worry about paying FICA taxes (Social Security or Medicare taxes), federal or state unemployment tax withholdings, or worker’s comp insurance. This gives you the ability to shift part of the business income ($71,600) to your kids, which will be taxed at a much lower rate (if at all), as compared to your effective tax bracket. Your children will have to pay taxes only on the income that they earn above and beyond the $12,000 standard deduction.
You can increase this an additional $5,500, and fund a deductible Traditional IRA for them as well. Now you’re able to pay them a total of $17,500 before one dollar of it will be taxed…and the tax rate on the first $9,525 above and beyond the $17,500 is only 10 percent!
To connect this to the original scenario: assume you pay each of your kids $10,000 per year for work they do in the practice. The grand total in tax liability to each of your kids? Zero. ($10,000 – $12,000 standard deduction = $0). The grand total to you had that money flowed through to your personal return (in the 22 percent bracket)? $4,400.
An added bonus: It is possible to take distributions out of Traditional IRA’s for higher education (college) costs in the future, so you could also view the Traditional IRA as an additional college savings vehicle (assuming you’ve already started saving in a 529). There are rules and requirements of these distributions to consider, which are beyond the scope of this article, so please be sure to consult with your tax advisor and certified financial planner to discuss whether this is a good strategy to employ.
It could also give you a great platform to teach your kids about how money works, the rules of investing and the amazing power of compounding interest.
Precautions to Take When Paying the Kids
There are specific rules that you must follow to be compliant about employing your children. Be sure to follow them and, again, consult your tax advisor to ensure that you’re in compliance.
First, each child will have to file a tax return, so depending on who you use for your tax prep services, you could see a slight increase in tax prep costs. However, their return is going to be so simple that it’s one that you could most likely do for free simply by downloading the 1040 from the IRS web site and writing it in by hand. Yes, you can still hand-write your tax return and mail in a paper copy to the IRS.
Their wages must also be reasonable for the work performed. Some examples of jobs that they could do would be web site updates and maintenance, social media page(s) manager and promoter, janitorial or other cleaning services. It also wouldn’t be uncommon to have the 16-year-old working in the optical during the summer months. Should you have to prove their legitimacy and work performed, be sure to have this work documented in their employee file.
Business entity structure is important. Your business needs to be set up as either a single-member LLC or sole proprietorship to pay them directly out of said business. If your practice is legally set up as an S-Corp, you’ll need to evaluate whether setting up a family management company (FMC) to provide support services to your S-Corp (practice) is worthwhile.
In addition, each state has specific child labor laws, so be sure to consult your attorney, or other qualified advisor, so you understand the age at which kids can be employed in your practice.
One misguided objection that I hear about paying kids is that clients don’t want to get subjected to the “kiddie tax.” The kiddie tax only applies to passive income (investment earnings, etc.) and not earned income, so the kiddie tax does not apply in this situation.
Overall, a Good Idea
Paying your children can be a win-win setup for both parents and children. Employing dependent children, when done correctly, is an opportunity to be tax savvy, and use the title of “business owner” to your advantage in a creative way.
Adam Cmejla, CFP® is a Certified Financial Planner Practitioner and Founder of Integrated Planning & Wealth Management, LLC, a financial planning & investment management firm. The company is focused on working with optometrists to help them achieve their true financial potential, build financial confidence and clarity, and deliver kindness and compassion to every relationship they’re privileged to serve. To contact: (317) 706-4748, firstname.lastname@example.org, or visit www.integratedpwm.com.