Brian Hufford, CPA, CFP®
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One of the most basic tax reduction strategies used by dentists is to employ family members to generate a lower overall family income tax burden. This column will update you on the latest family tax strategies.
Employment of spouse — If the dentist earns more than $106,800 (the Social Security maximum in 2010), employment of a spouse would typically not be a good strategy since the spouse’s earnings would subject the family to additional Social Security taxes of 15.3%. For example, assume the dentist earns $206,800 and pays a spouse $100,000 of salary. The family would pay Social Security taxes of 15.3% on the full $206,800 of income. Employment of a spouse only makes sense if the additional Social Security taxes (and other employment costs) would be offset by income tax savings.
In 2010, an employed spouse can contribute $16,500 to a 401(k) plan with an age 50 catch-up contribution of $5,500 for a total of up to $22,000. In addition, a spouse would receive additional matching contributions made by the dentist/employer. With a qualified retirement plan, employment of a spouse can offer significant income tax savings for the family. Make sure that your spouse meets the plan requirements (e.g., working more than 1,000 hours). Your spouse cannot contribute to a 401(k) plan through other employment and contribute to your plan.
Employment of kids — In 2010, the standard deduction for each child is up to $5,700 for wage income. The 10% federal income tax bracket goes up to $8,375. A child can earn wages of $13,075 and pay only $738 of federal income tax. The dentist would likely have to pay more than $4,000 in federal income tax to simply give a child the same amount. This is why wages for children working in the practice are such a great tax planning strategy. Now, enter the saboteur of kid’s employment, the corporation.
So many dentists practice as S Corporations. In the corporate form, this same $13,075 paid to a child becomes subject to nearly $2,600 of Social Security tax, unemployment tax, and other employment costs. This brings the total tax bill for the child up to approximately $3,500 as compared to the $738 that would be paid if the dentist practiced as an unincorporated entity, such as an LLC. Children under the age of 18 who work in an unincorporated dental practice are exempt from employment taxes. Child labor laws may apply in some states.
Children with sufficient earned income are eligible to contribute to Regular IRAs or Roth IRAs in an amount up to $5,000. Amounts may be withdrawn to pay for education without the 10% before-age-59½ penalty, although income taxes are paid on deductible amounts and investment earnings in Roth IRAs.
Finally, if you are audited by the IRS, you may need to justify amounts paid to your children through job descriptions or how appropriate compensation was determined.
The Kiddie Tax — There are numerous methods of shifting income to children without employing them in the practice. Think of the possibilities: An office building could be gifted to a family limited partnership with the children as substantial owners to receive rental income. Fully depreciated equipment could be gifted to a children’s trust and leased to the practice to generate rental income for the children and rental deductions for the practice. There are ways to shift income beyond imagination; however, these income-shifting methods only make sense if the children are in a lower income tax bracket than the parents.
The Kiddie Tax provisions were changed in the Tax Code so that any children who are full-time students under the age of 24 are taxed in their parents’ tax bracket on all unearned income, such as rentals, interest, dividends, and capital gains in excess of $1,900 in 2010.
What this means is that income-shifting strategies for unearned income for children under the age of 24 no longer make sense in most cases. For the most part, the change in the Kiddie Tax provisions has eliminated the ability to pay for college with unearned income from the dental practice.
Although many income-shifting strategies among family members have been eliminated due to changes in the Kiddie Tax rules to age 24 for full-time students — by simply paying your spouse a salary through the practice, funding full 401(k) benefits, and employing your children — you can save thousands of dollars of income taxes while advancing financial planning goals of retirement and college savings.
IRS Circular 230 Notice: This communication and any federal tax advice contained herein is not intended to be used, and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer or to promote, market or recommend to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064, or [email protected].
