But beware: The IRS is on the lookout for taxpayers who abuse this tax strategy.
If you hire your children as employees to do legitimate work in your business, you may deduct their salaries from your business income as a business expense. Moreover, if your child is under 18, you won’t have to withhold or pay any FICA (Social Security or Medicare) tax on the salary, subject to a couple of exceptions.
These rules allow you to shift part of your business income from your own tax bracket to your child’s bracket—which should be much lower than yours unless you earn little or no income. This tactic can result in substantial tax savings.
Your child will have to pay tax on the salary you pay them only to the extent it exceeds the standard deduction amount for the year. Fortunately, the standard deduction is quite large.
For 2023 (the taxes you file in April 2024), it is $13,850 for single taxpayers. In 2024 (taxes due in 2025), the amount goes up to $14,600. So, your child can earn up to those limits and owe no taxes on the income.
If you pay your child more than the standard deduction per year, they'll only have to pay tax at the rates shown in the following chart:
2023 Income Tax Rate |
Single Taxpayers |
10% |
$0 - $11,000 |
12% |
$11,001 to $44,725 |
22% |
$44,726 to $95,375 |
24% |
$95,376 to $182,100 |
32% |
$182,101 to $231,250 |
35% |
$231,251 to $578,125 |
37% |
over $578,125 |
For example, in 2023, a child has to pay only a 10% tax on taxable earned income up to $11,000 (taxable income means total income minus the standard deduction). So, a child could earn up to $24,850 and pay only a 10% income tax on $11,000 of it—that’s only $1,100 in tax on $24,850 in income.
2024 Income Tax Rate |
Single Taxpayers |
10% |
$0 to $11,600 |
12% |
$11,601 to $47,150 |
22% |
$47,151 to $100,525 |
24% |
$100,526 to $191,950 |
32% |
$191,951 to $243,725 |
35% |
$243,726 to $609,350 |
37% |
over $609,350 |
For 2024, a child could earn up to $26,200 and pay only a 10% income tax on $11,600 of it— a tax of $1,160 on $26,200 in income.
The IRS is well aware of the tax benefits of hiring a child, so it’s on the lookout for taxpayers who claim the benefit without really having their children work in their businesses.
If the IRS concludes that your children aren’t really employees, you’ll lose your tax deductions for their salary and benefits. And they’ll have to pay tax on their benefits.
To avoid this situation, you should follow these simple rules.
First of all, your children must be bona fide employees. Their work must be ordinary and necessary for your business, and their pay must be for services actually performed.
Their services don’t have to be indispensable, only common, accepted, helpful, and appropriate for your business. Any real work for your business can qualify.
You get no business deductions when you pay your child for personal services, such as babysitting or mowing your lawn at home.
On the other hand, the money you pay for yard work performed on business property could be deductible as a business expense. Your child can probably help you with lots of business-related tasks, such as answering phones, helping with your website, or cleaning the office.
The IRS has accepted that a seven-year-old child may be an employee. But it probably won’t believe that children younger than seven are performing any useful work for your business.
You should keep track of the work and hours your children perform. Many apps are available for this purpose, or you can create a timesheet yourself with a spreadsheet or on paper. It should list the date, the services performed, and the time spent performing the services.
Although not legally required, it’s also a good idea to have your child sign a written employment agreement specifying their job duties and hours. These duties should be related only to your business.
When you hire your children, it is advantageous (tax-wise) to pay them as much as possible. That way, you can shift as much of your income as possible to your children, who are probably in a much lower income tax bracket.
You can’t just pay any amount you choose: Your child’s total compensation must be reasonable. This amount is determined by comparing the amount paid with the value of the services performed.
You should have no problem as long as you pay no more than what you’d pay a stranger for the same work—don’t try paying your child $100 per hour for office cleaning just to get a big tax deduction. Find out what workers performing similar services in your area are being paid. For example, if you plan to hire your teenager to help answer the phone, call an employment agency or temp agency in your area to see what these workers are being paid.
To prove how much you paid (and that you actually paid it), you should pay your child by check or direct deposit, not cash. Do this once or twice a month as you would for any other employee.
The funds should be deposited in a bank account in your child’s or spouse’s name. Your child’s bank account may be a ROTH IRA, Section 529 college savings plan, or custodial account that you control until your child turns 21.
Finally, you must comply with most of the same legal requirements when you hire a child as you do when you hire a stranger. So, you must fill out IRS Form W-4 and complete U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification.
You must also record your employee’s Social Security number. If your child doesn’t have a number, you must apply for one. In addition, you, the employer, must have an Employer Identification Number (EIN). If you don’t have one, you may obtain it online at the IRS website (www.IRS.gov) or by filing IRS Form SS-4.
You must also complete and file IRS Form W-2 each year showing how much you paid your child.
If you have any questions about how you can save taxes by hiring your children, contact a tax lawyer.
]]>Fortunately, there is a long list of fringe benefits that are tax free and need not be included in the recipients' compensation. Tax-free employee fringe benefits include:
A detailed discussion of all the rules applicable to these fringe benefits is contained in IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits. Any benefit provided to an employee that does not comply with these rules is taxable income for that employee. For example, meals given to an employee who is required to be away from home overnight for rest are a tax-free fringe benefit. But non-overnight meals do not comply with this rule and are therefore taxable.
Here are some of the more common fringe benefits provided to employees that are taxable to the employee:
Excessive mileage reimbursements: Payments to an employee for business-related driving in his or her own car that exceed the IRS standard mileage rate are taxable income.
Moving expenses. In the past, employees who moved over 50 miles for their current job (not a new job) could receive tax-free reimbursement from their employer for their moving expenses. The Tax Cuts and Jobs Act made this fringe benefit taxable for 2018 through 2025. Reimbursement of expenses for employee moves of less than 50 miles have always been taxable.
Bicycle commuting. Until 2018, employers could also provide up to $20 per month to employees who commuted to work by bicycle. The Tax Cuts and Jobs Act makes this benefit taxable to employees during 2018 through 2025.
Clothing. Clothing given to employees that is suitable for street wear is a taxable fringe benefit.
Excessive education reimbursements. Payments for educational assistance that is not job related or that exceed the allowable IRS exclusion are taxable.
Awards and Prizes. Cash awards are taxable unless given to charity. Non-cash awards are taxable unless nominal in value or given to charity.
Expense reimbursements without adequate accounting. An employee must provide an adequate accounting for any expense reimbursement or it will be taxable income.
Working condition fringes. A working condition fringe benefit is tax free to an employee to the extent the employee would be able to deduct the cost of the property or services as a business or depreciation expense if he or she had paid for it. If the employee uses the benefit 100% for work, it is tax free. But the value of any personal use of a working condition fringe benefit must be included in the employee’s compensation, and he or she must pay tax on it. The employee must meet any documentation requirements that apply to the deduction.
Example: Sam, the owner of a small architecture firm, leases a computer and gives it to his employee Paul so that he can perform design work at home. If Paul uses the computer 100% for his work, it is tax free to him. But if he uses it only 50% of the time for work and 50% of the time for personal purposes, he would have to pay income tax on 50% of its value.
The value of the personal use is determined according to the benefit’s fair market value.
Example: It cost Sam $200 a month to rent the computer he gave Paul. If Paul uses the computer 50% of the time for work and 50% of the time for nondeductible personal uses, he would have to add $100 per month to his taxable compensation.
One of the most common working condition fringe benefits is a company car. If an employee uses a company car part of the time for personal driving, the value of the personal use must be included in the employee’s income. The employer determines how to value the use of a car, and there are several methods that may be used. The most common is for the employer to report a percentage of the car’s annual lease value as determined by IRS tables. For a detailed discussion of these valuation rules, refer to IRS Publication 15-B.
To learn more about business tax and deductions, see Nolo's Small Business Tax & Deductions center.
]]>If your losses exceed your income from all sources for the year, you have a “net operating loss” (NOL for short). While it’s not pleasant to lose money, an NOL can reduce your tax liability for the current and future years.
Figuring the amount of an NOL is not as simple as deducting your losses from your annual income. First, you must determine your annual losses from your business (or businesses). If you’re a sole proprietor who files IRS Schedule C, the expenses listed on the form will exceed your reported business income. If your business is a partnership, LLC, or S corporation shareholder, your share of the business’s losses will pass through the entity to your personal tax return. Your business loss is added to all your other deductions and then subtracted from all your income for the year. The result is your adjusted gross income (AGI).
To determine if you have an NOL, you start with your AGI on your tax return for the year reduced by your itemized deductions or standard deduction (but not your personal exemption). This must be a negative number or you won’t have an NOL for the year. Your adjusted gross income already includes all the deductions you have for your losses. You then add back to this amount any nonbusiness deductions you have that exceed your nonbusiness income. These include the standard deduction or itemized deductions, deduction for the personal exemption, nonbusiness capital losses, IRA contributions, and charitable contributions. If the result is still a negative number, you have an NOL for the year.
In the past, business owners could “carry a loss back”—that is, they could apply an NOL to past tax years by filing an application for refund or amended return. This enabled them to get a refund for all or part of the taxes they paid in past years. NOLs could generally be carried back two years. However, the Tax Cuts and Jobs Act (“TCJA”) has eliminated carrybacks for NOLs. Starting in 2018, an NOL may only be deducted against the current year’s taxes. However, a two-year carryback continues to apply for certain losses incurred by farming businesses.
Moreover, the TCJA permits taxpayers to deduct NOLs only up to 80% of taxable income for the year (not counting the NOL deduction). Any unused NOL amounts may be carried forward and deducted in any number of future years (under prior law, NOLs could be carried forward no more than 20 years).
The TCJA also limits deductions of “excess business losses” by individual business owners. Married taxpayers filing jointly may deduct no more than $500,000 per year in total business losses. Individual taxpayers may deduct no more then $250,000. If a business is owned through a multi-member LLC taxed as a partnership, partnership, or S corporation, the $250,000/$500,000 limit applies to each owners’ or members’ share of the entity’s losses. Unused losses may be deducted in any number of future years as part of the taxpayer's net operating loss carryforward. This limitation takes effect in 2018 and is scheduled to last through 2025.
In response to the COVID-19 pandemic, Congress passed the Coronavirus Aid Relief and Economic Security Act (CARES Act) in 2020. The CARES Act reinstated old NOLs rules and even made them more favorable than they were prior to the TCJA. Under these new temporary rules, NOLs occurring in 2018, 2019, and 2020 can be used to offset 100% of income earned during those years, instead of just 80%. In addition, NOLs incurred during 2018 to 2020 can be carried back five years and the carried back NOLs are not subject to the 80% income limitation. Thus, if they are large enough, they can completely eliminate the tax liability for these years resulting in a tax refund.
For more on the temporary NOLs tax relief measures under the CARES Act, see Tax Relief for Businesses With Net Operating Losses (NOLs) Under CARES Act.
]]>Money-losing businesses were valuable tax shelters because taxpayers could freely deduct all the losses they incurred from such investments from the other income they earned. This led to enormous abuses. In the 1980s, wealthy individuals invested in real estate limited partnerships and other tax shelters created solely to generate large losses through depreciation, interest, and other deductions. The investors in these tax shelters would use their paper losses to offset their other real income. The tax benefits obtained could far exceed the amount of money invested in the tax shelter.
All this came to an abrupt end in 1986 when Congress enacted the passive activity loss rules. (I.R.C. Section 469.) These rules were designed to limit a taxpayer’s ability to use real estate or business losses to offset other income. The PAL rules apply to all business activities, but are particularly strict for real estate rentals because they were the primary tax shelter.
The passive activity loss rules created a special category of income and loss called passive income or loss. There are two types of passive income or loss. Passive income or loss comes from:
It's easy to know whether you have income or loss from real estate rentals. But the concept of "material participation" is more complicated. You materially participate in a business only if you are involved with its day-to-day operations on a regular, continuous, and substantial basis. (I.R.C. Section 469(h).) The IRS has created several tests to determine material participation, based on the amount of time you spend working at it.
The most commonly used test is the 500 hour test: you materially participate in any business in which you work more than 500 hours during the year. For example, a person who owns a restaurant and spends more than 500 hours per year working in it actively participates in the business. The income or loss that person incurs from the business is active, not passive. On the other hand, a person who invests in a restaurant, but spends no time at all actually working in the business, does not materially participate in the business. His or her income or loss from the restaurant is passive income or loss.
Note that even if you work over 500 hours per year at real estate rentals, the income remains passive. The only exception is if you qualify as a “real estate professional." To do so, you must spend over 51% of your time (and at least 751 hours) working in real estate businesses each year and materially participate in your rental activity. However, a special rule allows landlords with up to $100,000 in total income to deduct up to $25,000 in rental losses each year.
Why is all this important? Because you can deduct passive losses only from passive income, not from income from other sources such as earnings from a job or a business you actively manage. In addition, passive income does not include investment or dividend income.
Example: Sidney is a successful doctor. This year, he has $200,000 in income from his practice (salary income) and also earns $50,000 in income from investments (investment income). Sidney invests $25,000 in a real estate limited partnership tax shelter. The partnership owns several rental properties that operate at a substantial loss. At the end of the year, the partnership informs Sidney that his share of the partnership’s annual operating loss is $75,000. Sidney invested in the limited partnership because he wanted to use his share of the losses it generated to reduce his taxable income from his medical practice. However, come tax time, he’s in for a shock. Because passive losses are only deductible from passive income, Sidney cannot deduct his $75,000 passive loss from his medical practice income or his investment income. He earned no passive income during the year so he can’t use his passive loss at all this year. His real estate tax shelter turned out to be useless.
This is what the passive activity loss rules are intended to do: prevent you from deducting your passive losses (such as from rental activities or businesses in which you don't actively work) from your non-passive income. Thus, there is no point in investing in real estate rentals or other passive activities just to incur tax losses because you won’t be able to use these losses to offset your other non-passive income.
The Tax Cuts and Jobs Act (TCJA), the massive tax law enacted by Congress that took effect in 2018, did not alter the passive loss rules. They remain in place. However, the TCJA added new restrictions on deducting losses from businesses in which taxpayers materially participate as well as losses from real estate rentals incurred by real estate professionals. Starting in 2018 and continuing through 2025, married taxpayers filing jointly may deduct no more than $500,000 per year in such losses over their business and/or rental income. Single taxpayers may deduct no more then $250,000.
In other words, you may deduct losses equal to your total income from all your businesses and rentals and an additional $250,000 or $500,000. The effect is that no more than $250,000/$500,000 in business and/or rental losses can be deducted from nonbusiness or nonrental income in any one year during 2018 through 2025. The $250,000/$500,000 limit applies after the passive loss rules are applied. Unused excess business losses are deducted in any number of future years as part of the taxpayer's net operating loss (NOL) carryforward.
The excess business loss limitation applies to the total (aggregate) income and deductions from all of a taxpayer’s trades or businesses, including rental and nonrental businesses. If spouses filing jointly have separate businesses, the $500,000 limit applies to the total income and deductions from all of their businesses, rental and nonrental. If a business or rental property is owned through a multi-member LLC taxed as a partnership, partnership, or S corporation, the $250,000/$500,000 limit applies to each owners’ or members’ share of the pass-through’s losses.
Example: Sheila, a single taxpayer, is co-owner of a new struggling restaurant. She materially participates in the restaurant business, thus the passive loss rules don’t prevent her from deducting her losses from the restaurant from her nonpassive income. In 2018, her share of losses from the restaurant amount to $270,000. She may deduct only $250,000 of this amount. The remaining $20,000 is carried forward to next year as a net operating loss.
To learn more about what you can or can't deduct, see Nolo's section on Business Deductions.
]]>Are gifts like these tax-deductible business expenses? Yes, but they are subject to draconian limits.
If you give someone a gift for business purposes, your business expense deduction is limited to $25 per person per year. Any amount over the $25 limit isn't deductible. If this amount seems awfully low, that’s because it was established in 1954!
A gift to a member of a client's family is treated as a gift to the client unless you have a legitimate nonbusiness connection to the family member. If you and your spouse both give gifts, you're treated as one taxpayer—it doesn’t matter if you work together or have separate businesses.
The $25 limit applies only to gifts to individuals. It doesn’t apply if you give a gift to an entire company unless the gift is intended for a particular person or group of people within the company. Such company-wide gifts are deductible in any amount, as long as they're reasonable.
To learn more about making the most of your business deductions, get Nolo's Deduct It! by Stephen Fishman, J.D.
]]>First of all, for tax purposes there are two types of people who own vacant land: investors and real estate dealers. Real estate dealers are in the business of buying and selling land. A dealer buys property and resells it, usually at a price higher than the purchase price, and normally after only a short holding period. A good example is a subdivider who buys large tracts of vacant land, divides them into smaller lots, and then resells the lots piecemeal. Numerous and continuous sales over an extended time period are the hallmark of a real estate dealer.
Real estate dealers are entitled to the much the same deductions as any other business owner. They can deduct all the expenses of owning the vacant land they buy and sell, including interest, taxes, and other carrying costs. If you are a sole proprietor, these are deducted on IRS Schedule C.
On the down side, all the profits real estate dealers earn from their business are taxed at ordinary income rates instead of capital gains rates. Moreover, they must pay Social Security and Medicare taxes on their net self-employment income, as well as income tax. Also, real estate dealers are not allowed to take depreciation deductions. So if the land has structures on it, their cost cannot be deducted.
A person who purchases real estate as an investment is not in the business of buying and selling vacant land on a continuous and extended basis. Rather, he or she purchases land and usually holds on to it for some time in the hope that it will appreciate in value. Since an investor is not engaged in a business, he or she is not entitled to business deductions and does not file Schedule C.
However, many investment expenses are deductible as personal itemized deductions on Schedule A. These expenses are an ordinary tax deduction that results in tax benefits at your regular income tax rate, which can be as high as 37% in 2018 through 2025 (40.8% if you're subject to the new Medicare net investment income tax).
Any interest an investor pays on money borrowed to purchase vacant land is investment interest that can be deducted as an itemized personal deduction. However, the annual deduction for investment interest is limited to the investor's net investment income for the year. Any excess is carried over to future years. You determine the amount of your net investment income by subtracting your annual investment expenses (other than interest expenses) from your investment income.
Example: George purchases a vacant lot on which he pays annual property taxes of $1,000 and interest of $2,000. His only other investment is a savings account which earns $2,000 in annual interest. His net investment income is $1,000 ($2,000 interest income - $1,000 property tax expense = $1,000. Thus he may deduct only $1,000 of his interest expense. The excess $1,000 is carried over to future years.
An investor can also deduct property taxes paid on a vacant land as a personal itemized deduction on Schedule A. This deduction is not limited to the amount of net investment income. Nor is it subject to the $10,000 annual limit on deducting property tax paid on a main or second home. The $10,000 limit, enacted for 2018 through 2025 by the Tax Cuts and Jobs Act (TCJA) does not apply to investment property.
Until 2018, other carrying costs, such as legal and accounting fees, landscaping, insurance, and travel expenses, could be deducted as miscellaneous itemized deductions on Schedule A, but only to the extent the exceeded 2% of the taxpayer's adjusted gross income. However, the Tax Cuts and Jobs Act eliminates all such deductions by individual taxpayers during 2018 through 2025. And, you can’t add these expenses to your property’s basis as described below. Thus, these expenses have no tax benefit during 2018-2025.
If you don't itemize your deductions on your tax return, you won't be able to deduct the property tax and interest expenses you incur from owning vacant land. In this event, you should elect to add these expenses to your land's cost basis. This will reduce any taxable profit you earn when you sell the property.
Example: Jean purchases a vacant lot for $10,000. Over the next four years she elects to add $5,000 in carrying costs to the lot's cost basis. At the end of that four years, her adjusted basis in the lot is $15,000. She sells the lot for $20,000. Her taxable gain is only $5,000 ($20,000 sales price - $15,000 adjusted basis = $5,000).
You must make an annual election to add these costs to your land's basis--"capitalize" them in tax jargon. You can elect to capitalize all your costs, or capitalize some and not others--for example, you could capitalize interest but not property taxes.
To make this election you should add a statement like the following to your tax return:
"For tax year _____, taxpayer hereby elects under Code Section 266 and IRS Regulations 1.266-1 to capitalize, rather than deduct, property taxes and mortgage interest on the 111 First St. vacant lot."
You need to make this election each year you want to add these costs to your land's basis. If you wish, you can make the election some years you own the property, and not make it in others.
If you are interested in learning more about purchasing and building on vacant land browse these informative vacant land articles.
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