Income Shifting to Children

A fundamental tax-mitigation technique is shifting income from taxpayers in high tax brackets to taxpayers in lower brackets. One of the ways this can be accomplished for business owners is by paying their children a salary for working for the business. Not only does this shift taxable income from the parent's higher-bracket to the children's lower-bracket while keeping everything within the family, this technique can also save payroll taxes compared to hiring non-family employees.

According to the IRS, "[p]ayments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child." Furthermore, children claimed as dependents on a parent's return and who make less than $6,200 for 2014 do not owe any income tax and are not required to file a tax return, although filing would be necessary in order to receive a refund of income tax withheld.

A parent can also match the child's wages up to $5,500 with a Roth IRA contribution in the child's name. This will reduce the parents' future tax on investment income by the amount of the return on the contribution, which would grow tax-free.

In addition to passing income in the form of "active" wages to children, "passive" income can also be passed to children. In order to take advantage of this opportunity, the "kiddie tax" must be avoided. If the tax applies, the income is taxed at the parent's highest rate instead of the child's, completely negating the strategy. However, parents can still transfer income-generating assets to children, and if the income for the tax year is under $2,000 in 2014, the child's lower rate applies. As children reach the age of majority and continue earning substantially less than their parents, the opportunities to shift passive income increases.