Tax Services • Published 5/04/2021 Helping Your Teenager Navigate Income Tax

As summer approaches, many teenagers are lining up a summer job or looking forward to spending their extra time working in their parents’ business. For teenagers and college students, this may be the first time they face the realities of income tax. In this article, we cover a few of the myriad tax considerations to be mindful of if your child works for you or starts a summer job while still classified as your dependent.

Income Tax Withholding for a Summer Job

If your high school or college student gets a job working at the local fast food restaurant, they’ll be asked to complete employee-related paperwork such as a Form W-4 and a state equivalent (in Louisiana, this is an L-4) to set any income tax to be withheld from their paychecks. While this may seem fairly mundane, carefully completing these forms can save some time and money later depending on how much they project to earn.

Currently, for U.S. income tax purposes, a taxpayer can earn gross income up to the standard deduction (projected as $12,550 for 2021) and owe ZERO federal income tax. So, if your child’s total income for 2021 – wages plus all other income such as interest income, etc. – is expected to be under $12,550, they can set their federal income tax withholding at zero. They may still need to withhold state income tax, but if your child is a Louisiana resident and works in Louisiana, they may earn up to $4,500 and owe zero Louisiana income tax as well. If that is the case, they could set their withholding on Form L-4 such that no income tax is withheld. In this case, your child can avoid needing to file an income tax return for 2021.

We often see children of clients filing tax returns to recoup the tax withheld from their wages, but the cost and time to file sometimes outweighs the refund. If the income projected to be earned is under the thresholds above, the time and expense of filing can be avoided, while putting more dollars in their pocket from every paycheck.  

Key Tax Considerations of Employing Your Child

If you own a business, employing your child can be a significant benefit from an income tax perspective, but it requires diligent planning and documentation. As noted above, your child’s standard deduction is projected to be $12,550 for 2021. If your child has no other income, your business could pay them up to $12,550 and that income will not be subject to income tax since it will be offset by their standard deduction. Your business would deduct the salary as a regular business expense while your child receives wages free of income tax. In certain situations, the income will not be subject to Social Security or Medicare tax, either. This option may sound too good to be true, but it is subject to several rules and considerations:

• If your child is under age 18 and your business is a sole proprietorship (including a single-member LLC) or a partnership where both parents are the only partners of the partnership, then the business is not required to pay or withhold Social Security or Medicare tax (FICA taxes) nor pay federal unemployment tax (FUTA). In this case, the child’s wages (up to $12,550) may be completely tax-free (unless state income tax and/or state unemployment tax apply), while qualifying as a deductible expense for your business!
• If your business is a corporation or an S-corporation, your employed child’s wages are subject to FICA and FUTA taxes but could still escape income tax to the extent they do not exceed the child’s standard deduction. The corporate entity and individual would incur a combined 15.3% FICA rate on the wages, so the income tax benefit would need to be weighed against this cost. Often, the income tax benefit will still result in overall tax savings—especially for parents in a higher income tax bracket.
• The wage earnings of the child may be used to fund Roth IRA contributions, thus providing exponential possible future tax savings. In order to make a Roth IRA contribution, a taxpayer must (a) have earned income and (b) have adjusted gross income below a range of $125,000 to $140,000 (assuming single filing status). Assuming your teenager doesn’t have a very unusual income level, a Roth IRA can be funded up to the lesser of the child’s earned income or $6,000. While the Roth IRA contribution does not result in a tax deduction, it grows tax-free and is tax-free when withdrawn, so starting a Roth IRA at age 15 or 16 can yield substantial growth over a 50-year period.

As noted above, you still need to diligently plan and document situations where you are employing your child because there are important requirements and considerations aside from the potential tax windfall.

• Your child must be a “real” employee and provide bona-fide services to your business. Just putting them on the payroll is not enough. Document their work hours and duties and respect the employee-employer relationship when it comes to typical employment-related protocols such as having Form W-4 on file and filing the annual Form W-2 to report wages.
• Compensation paid must be reasonable in light of the value of the services performed. From a tax standpoint, shifting as much income as possible to your child or children may seem like the most advantageous strategy, but if you pay your child $200 per hour to answer the phone, the deduction would likely not pass muster upon an IRS examination.
• While the Fair Labor Standards Act (FLSA) requirements are beyond the scope of this article, make sure you are familiar with any potential restrictions. The good news is that many of the FLSA restrictions on hiring workers under age 18 don’t apply when a child is employed in a business owned solely by their parents. However, there are other important requirements to be aware of.

Creating a Plan

As your teenager or college student embarks upon any new employment, be wary of the impact it may have on your ability to claim your child as a dependent. Depending on your situation, you may still be eligible for the Child Tax Credit, which was substantially enhanced by the 2017 Tax Cuts and Jobs Act (TCJA). In order to claim the Child Tax Credit, your child must still qualify as a dependent. One of the determinations is the “support test,” which states that you must provide at least half of your child’s support for the year. While it is unlikely that a $12,500 or so salary would allow your child to provide more than half of their own support, just be aware of this potential nuance in the event your child has other sources of income.

Whether your child is looking for a summer job or working at the family business this summer, they likely need some guidance in matters of income tax strategy. There are some great potential tax advantages—for your child and possibly for you—that can result from a little careful planning and foresight. Contact your P&N tax advisor for more information.