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Here’s Two College Tax Strategies That You Can Use to Attract Small Business Owners

COVID-19 has put many small business owners at risk. Sales are down for most, some have had to borrow money to keep employees, and some have even cut their salaries to keep the business running. If a business owner also has children attending or about to attend college, it only adds to the burden.

One of the best combo strategies I ever used with high net worth business owners was to hire their kid in their business and then write off the cost of the kid’s new leased car as a business expense. If you’re a CPA, accountant, or tax-oriented financial advisor, these two tax strategies can cut taxes and increase income for small business owners and help them save and pay for college expenses. Now with the new 2018 tax laws, these strategies have become an even better conversation piece and cash flow strategy (ie. $12,000 standard deduction). Let me explain.

 “Hiring your Kids” Tax Strategy

The first tax strategy is “Hiring your Kids” in your business. Hiring your kids in your business is a good tax planning strategy, but is also an excellent way to teach them about business as well. It’s also a good way to save for the children’s college education. However, since hiring your children is a tax planning strategy, there are some specific rules you need to follow to avoid running afoul of the IRS.

Wages paid to your children are a valid business deduction, as long as they do bona fide work, and they are compensated fairly. The age range for hiring your children is seven years old (the IRS suggested minimum age for employment) and older. However, there may be legitimate cases where you can employ even younger children, such as in business advertising.

How To Qualify For The “Hire Your Kids” Tax Strategy

The work duties performed by your children must be related directly to the business. In other words, you can’t pay them a wage for doing chores around the house and deduct that wage from your business. Officially, you should draw up an employment agreement documenting the duties that your child will perform, and the amount he or she will be compensated.

The employer should also keep track of the hours that the child works, similar to a non-family employee. Therefore, you should use a time card to track your child’s hours worked. You should pay the child a reasonable wage for those duties. You should pay them the same amount (or less) that you would pay a non-family member to do the same work, but never pay them more.

You should complete a W-4 for your children when you hire them and pay them from your business checking account to document your children’s pay. You should also provide them with a W-2 at the end of the year and file quarterly payroll reports, even though tax may not be due.

The money that you pay your child must be used as they wish; otherwise, it will not be considered as valid compensation by the IRS. That means you cannot force your child to use the money to save for college. If you do want to use these wages for college tuition, you should set up a separate bank account for the child and write checks for the college tuition from that child’s bank account.

Benefits Of The “Hire Your Kids” Tax Strategy

Hiring your children is a good way to fund a college savings account, or directly pay college tuition while the student is attending school. There are several accounts they can use to save for college, including a 529 account, a Coverdell Education Savings Accounts, an IRA, or a UGMA or UTMA account.

If you earn too much to qualify for a Hope or Lifetime Learning tax credit, you can allow your child to claim one of these credits. Furthermore, earned income is not subject to the ‘kiddie tax’, so you don’t have to report your child’s income on your tax return and pay taxes at your higher tax rate.

The children can also use their earned income to build a savings account or even a retirement account. In 2020, your children can contribute up to $5,500 of their earned income to a traditional IRA or a Roth IRA, and $13,500 to a SIMPLE IRA. A traditional IRA will allow them to shelter any income earned above the $12,000 standard deduction from taxes, but a Roth IRA may offer a larger tax benefit since the earnings are tax-free, as long as your child follows the withdrawal rules.

Tax Savings Involving The “Hire Your Kids” Tax Strategy

The tax benefit of hiring your children comes from effectively shifting income from your higher tax bracket to their lower tax bracket. Because most children are in a lower tax bracket (10%-12%), the business owner can save money by hiring their children, paying them wages, and then have them purchase items that the business owner would pay for, such as college tuition.  

If you are self-employed and your child is under age 18, you don't have to pay Social Security or Medicare payroll taxes on their wages. If they are under age 21, you do not have to pay unemployment taxes on them. This is a big tax saving since you would have to pay these taxes for any other employee you hired.

In 2020, earned income below the standard deduction is not subject to tax, so your child can essentially earn up to $12,000 before he or she would owe any income tax. Most children are in the lowest tax bracket, which is 10% for taxable income under $9,875 in 2020. Since most parents who own their own business are in a higher tax bracket, ranging from 22% up to 37%, by paying your child a wage, you are effectively shifting income from your higher tax bracket to their lower tax bracket. This is a great way to reduce the family’s total tax liability.

Example Of The “Hire Your Kids” Tax Strategy

In 2020, Tom paid his 16-year-old son (James) $7,200 in wages for work on Tom’s business website. Since James’ earnings are under the $12,000 standard deduction amount, he does not owe income taxes on those earnings. Also, because James is under age 18, Tom does not have to pay Social Security, Medicare, or unemployment taxes as he would with a regular employee.

Tom currently pays 24% in federal taxes, 6% in state taxes, and 15.3% in self-employment taxes, for a total tax rate of 45.3%. Because Tom can deduct his son’s wages from his business profit, Tom saves $3,262 in taxes ($7,200 x 45.3%). Tom often gives his son $7,200, or more, during the year for personal items. By employing his son and paying him wages instead, Tom can save considerable money in taxes. This is an incredible tax planning strategy for small business owners with children under the age of 18.

Let’s take it one step further. Let’s assume Tom paid James $12,700 in 2020, and James puts $5,500 of the wages into a traditional IRA and the remaining $7,200 into a bank account. Using this strategy, Tom’s son still does not owe a dime in taxes and has saved $12,700 that he can use for upcoming college expenses. In turn, Tom now saves $5,753 in taxes ($12,700 x 45.3%) on money that he would have used to pay his son’s college expenses.

Note: Tom’s son would owe taxes on the $5,500 IRA once the money was withdrawn for college expenses, but those taxes would be little or none. Furthermore, there is no tax penalty on money withdrawn from an IRA, if the money is used for qualified college education expenses.

“Deducting the Employed Child’s Car as a Business Expense” Tax Strategy

An employee's (child) use of an employer-provided auto for company-related business can be considered a ‘working condition fringe benefit’ to the employee. In other words, if the employee uses the company car for business use, the value of the company car is deductible to the business owner, and is excluded from an employee’s income.

However, if the employee uses the company car for personal use, the business owner can still deduct the annual cost of the leased vehicle, but the employee must include the amount of his or her private use of the car as compensation (income).

Since the standard deduction for a single person (child) was raised to $12,000 in 2018, as long as the wages and personal use of the car is under that $12,000 threshold, the business owner could write off the entire $12,000 as a business expense and the child would not owe any federal income tax.

Let’s look at this in detail.

How to Qualify for “Deducting the Child’s Car as a Business Expense” Tax Strategy

A working condition fringe benefit is any employer-provided property or service that could be deducted as an employee business expense if the operation of the vehicle is directly paid for by the employee. Thus, only the value of the non-business use of a company car is taxable compensation to an employee.

As such, if you employ your child in your business, the child can exclude from his or her taxable income the value attributable to use in the small business owner’s (employer) company per IRC 1.132-5(b)(1)). However, the amount of any personal use of the auto is considered a fully taxable fringe benefit (i.e., additional taxable wages).

The following persons are considered employees for purposes of determining whether the business owner can exclude the value of a company car may as a working condition fringe benefit:

• Any individual (child) currently employed by the business owner,
• Any partner performing a service for the partnership,
• Any director of the employer, and
• Any independent contractor who performs a function for the employer.

Benefits of “Deducting the Child’s Car as a Business Expense” Tax Strategy

All business use of a company car qualifies as a working condition fringe benefit and, therefore, the business owner can deduct 100% of the value of that business use from the employee’s (child’s) income. Furthermore, if the personal use of a company car is included in an employee’s (child’s) wages as taxable compensation, the employer can deduct the cost of the company car as if it were used entirely for business purposes.

Form 4562, Part V, Section A, on the employer’s tax return would show the business-use percentage as 100%.

Tax Savings Involving “Deducting the Child’s Car as a Business Expense” Tax Strategy

The tax benefit of deducting the child’s car as a business expense is two-fold:

1. The business owner (employer) can deduct the entire yearly cost of the company car as if it were used entirely for business purposes
2. The personal use of a company car is included in the child’s (employee) wages as taxable compensation, but since the (single) child is allowed a standard deduction of $12,000 in 2018, the taxes incurred by the child will be minimal.

Example of “Deducting the Child’s Car as a Business Expense” Tax Strategy

Tom is a self-employed business owner who hires his child James (age 16) as an employee of his company. Tom leased a 2018 Honda CRV on January 1, 2020, for James to use for both business and personal use. The lease cost of the vehicle is $350/month, and during the year (2020) James drives the car a total of 10,000 miles, of which 9,000 miles was personal use (including college).

At the end of the year, Tom deducts the $4,800 yearly cost of the vehicle ($4,200 lease and maintenance, insurance, etc. of $600) as a business expense and issues James a W-2 for $4,320 for the personal use of the company, owned vehicle (9,000 miles / 10,000 miles x $4,800 = $4,320).

James also earned $7,200 ($600/week) in wages during the summer (home from college). Therefore, James’ total income reported on his W-2 was $11,250 ($7,200 wages + $4,320 personal auto use). At the end of the year, James owes $0 in federal tax.

Tom currently pays 24% in federal taxes, 6% in state taxes, and 15.3% in self-employment taxes, for a total tax rate of 45.3%. Because Tom can deduct James’ wages and the entire cost of James’ car from his business profit, Tom saves $5,096 in taxes ($11,250 x 45.3%). James now has $11,250 saved for his first year in college, and Tom has $5,096 in tax savings that he can use to pay college expenses. 

Now let’s look at the steps and the documents you will need to implement each of the two tax strategies:

Implementing the “Hire Your Kids” Tax Strategy

• Step 1: Determine the duties, develop a reasonable compensation for the child, and set up a systematic payroll (bi-weekly, monthly, quarterly, or yearly).
• Step 2: Execute an employment agreement with the child – when hiring your child you need a formal hiring process that should include the completion of a standard Employment Application, W-4 form, and an I-9 form.
• Step 3: Set up a separate checking account in the child’s name to deposit the earnings. This account must be separate from the parents’ bank account.
• Step 4: Record the child’s services performed using a monthly timesheet.
• Step 5: Pay the child using a business check each month
• Step 6: Deposit a child’s check into the child’s checking account each month
• Step 7: Issue monthly payroll tax reports – IRS Form 941
• Step 8: Issue IRS Form W-2 to the child each year of employment
• Step 9: Fill out a yearly Form IRS Form 1040 for the child

Documents Used To Complete the “Hire Your Kids” Tax Strategy

The following are the documents you will need to Hire Your Kids in your business:

• Employer identification number (IRS SS-4 Form)

• Employment Application, W-4 form, and an I-9 form
• Monthly timesheets

• Monthly payroll tax reports (IRS Form 941)

• Issue IRS Form W-2 to the child each year of employment

• IRS Form 1040 for the child

Implementing the “Deduct the Child’s Car as a Business Expense” Tax Strategy

• Step 1: EMPLOYER – Calculate the personal use cost of the company car that must be charged back to the employee as income.
• Step 2: EMPLOYER – Use Form 4562, Part V, Section A, on the employer’s tax return to show the business-use percentage as 100%.
• Step 3: EMPLOYER - Issue IRS Form W-2 to the child each year for the cost of the personal use of the company vehicle.
• Step 4: EMPLOYEE - An employee must substantiate both business and personal use of the company vehicle using itemized records. The records should contain:
  • Each date the company car is used for business purposes
  • The mileage used for business purposes
  • The business purpose of the trip and description of the destination
  • The total company car mileage for the year

Note: Keep an accurate account of the business use of the vehicle. Without reliable, written records, IRS may disallow the exclusion-from-income status of the employer-provided company car.

• Step 5: EMPLOYEE – Issue a “Statement From Employee To Employer Regarding The Use of Employer-Provided Auto”

Documents Used to “Deduct the Child’s Car as a Business Expense” Tax Strategy

These are the documents you will need to deduct the child’s car as a business expense:

• Itemized records of business use of the company-owned auto
• Form 4562, Part V, Section A
• Statement from employee to employer regarding the use of an employer-provided vehicle
• Issue IRS Form W-2 to the child each year of employment
• IRS Form 1040 for the child