Running Your Kids Payroll Through Your Dental Practice
Dental CPA Update – Dental ROI Associates – Results by Design
New Kiddie Tax Rules Under the Tax Cuts and Jobs Act
Many dentists find it beneficial to pay their children through their dental practice. Not only to pay them for services they provide, but also to save the dentist and dentists family taxes. Keep in mind when paying your child through the practice records should be kept showing what services they provided and when they worked. With differences in tax brackets between the dentist and the child, there can be meaningful tax savings.
For 2018–2025, the Tax Cuts and Jobs Act (TCJA) tax reform changes the kiddie tax rules to tax a portion of an affected child’s or young adult’s unearned income at the federal income tax rates paid by trusts and estates.
Trust tax rates can be as high as 37 percent or, for long-term capital gains and qualified dividends, as high as 20 percent. Trust and estate rate structure is unfavorable because the rate brackets are compressed compared with the brackets for a single individual. So you get into higher tax brackets more quickly.
Unearned income means income other than wages, salaries, professional fees, and other amounts received as compensation for personal services. So, among other things, unearned income includes capital gains, dividends, and interest.
Kiddie Tax Basics – Paying Your Child Through Your Dental Practice
The kiddie tax can apply until the year during which a dependent child or young adult turns age 24. Put another way, the kiddie tax can never apply to someone who is age 24 or older at year-end.
For someone who is age 19–23 at year-end, the kiddie tax can apply only if he or she is a full-time student for that year.
But a child age 18 or under at year-end with significant unearned income is usually exposed to the kiddie tax.
By “dependent child or young adult,” the law means a child of yours for whom you could claim a dependent exemption deduction under prior law, because you pay over half of his or her support for the year.
Under the kiddie tax rules for 2018–2025, a portion of your dependent child’s or young adult’s net unearned income can be taxed at the federal income tax rates paid by trusts and estates.
Calculating the Kiddie Tax
If your dependent child (or young adult) is subject to the kiddie tax, he or she is allowed to deduct his or her standard deduction.
The 2018 standard deduction for a dependent child is the greater of (1) $1,050 or (2) earned income + $350, not to exceed $12,000.
The 2019 standard deduction for a dependent child is the greater of (1) $1,100 or (2) earned income + $350, not to exceed $12,400.
To calculate the federal income tax bill for a child (or young adult) under the kiddie tax rules for 2018–2025, you first add the child’s net earned income and net unearned income. Then subtract the child’s standard deduction to arrive at taxable income. The portion of taxable income that’s deemed to consist of net earned income is taxed at the regular rates for a single taxpayer. The portion of taxable income that’s deemed to consist of net unearned income and that exceeds the unearned income threshold ($2,100 for 2018 and $2,200 for 2019) is subject to the kiddie tax and is therefore taxed at the rates for trusts and estates. For 2018–2025, the kiddie tax can be much more expensive for a child with substantial unearned income, because the trust and estate tax rates rise so quickly to the maximum 37 percent rate (or the maximum 20 percent rate for long-term capital gains and qualified dividends). Here are the trust and estate rate brackets for 2018 and 2019:
2019 Trust and Estate Rate Brackets for Ordinary Income
10 percent tax bracket $ 0–2,600
Beginning of 24 percent bracket 2,601
Beginning of 35 percent bracket 9,301
Beginning of 37 percent bracket 12,751
2019 Trust and Estate Rate Brackets for Long-Term Capital Gains and Qualified Dividends
0 percent tax bracket $ 0–2,650
Beginning of 15 percent bracket 2,651
Beginning of 20 percent bracket 12,951
Ways to beat the kiddie tax when paying your child through your dental practice.
Generate Earned Income
The kiddie tax cannot hit a child who is age 18–23 if his or her earned income exceeds 50 percent of his or her support for the year. The law does not require your child to actually spend any of the earned income on his or her support. The child could simply bank all the earned income and still pass the more than 50 percent support test if there is enough earned income. When your child is not your dependent for the year because he or she provides over half of his or her own support, your child can claim the full standard deduction on his or her Form 1040.
For 2018, the full standard deduction for a single taxpayer is $12,000. For 2019, the standard deduction for a single taxpayer is $12,400.
In contrast, when your child is your dependent, the standard deduction is limited.
For 2018, the limit is the greater of (1) $1,050 or (2) earned income + $350, not to exceed $12,000.
For 2019, the limit is the greater of (1) $1,100 or (2) earned income + $350, not to exceed $12,400.
More earned income can potentially allow your child to claim a full standard deduction, because the child provides over half of his or her own support and is therefore not your dependent.
Even for a child who is your dependent, more earned income can increase the standard deduction. The increased standard deduction can potentially shelter all of your child’s earned income and then some. For instance, a dependent child with $11,000 of earned income in 2019 can claim an $11,350 standard deduction.
Earned Income Avoids Kiddie Tax for 20-Year-Old Community College Student
Your 20-year-old daughter is an unmarried full-time community college student. She has $6,800 of ordinary unearned income in 2019 from investments held in a custodial account that you set up by pay her though your dental practice to help cover her college costs. The kiddie tax unearned income threshold for 2019 is $2,200.
Based on these facts, her 2019 taxable income is $5,700 ($6,800 unearned income - $1,100 standard deduction). The kiddie tax hits $4,600 of that income ($6,800 - $2,200 unearned income threshold), so that amount is taxed at the trust and estate tax rates.
- The first $2,600 is taxed at 10 percent, resulting in $260 of tax.
- The next $2,000 is taxed at 24 percent, resulting in $480 of tax.
- The last $1,100 is taxed at the regular 10 percent rate for a single taxpayer, resulting in $110 of tax.
So your child’s 2019 federal tax bill totals $880 (kiddie tax of $260 + $480 + regular tax of $110).
Key Point: Without the kiddie tax, your child’s $5,700 of taxable income would be taxed at 10 percent under the regular rates for a single taxpayer, resulting in only $570 of tax.
Variation: What would happen to your daughter’s 2019 tax situation if she also had $12,000 of earned income from a part-time job or from working for your family business? Her tax bill could actually go down. Here’s why:
1. Assume your daughter’s total 2019 support (including $6,000 for community college tuition, fees, and books) amounts to $23,000. She pays $18,800 of the support herself with the $6,800 of unearned income and the $12,000 of earned income.
2. Since her earned income ($12,000) exceeds 50 percent of her support ($23,000), she is kiddie tax– exempt for 2019.
3. Because she pays over half of her own support, she is not a dependent for 2019. Therefore, she is entitled to a full $12,400 standard deduction.
4. When all is said and done, your daughter’s taxable income is only $6,400 ($6,800 unearned income + $12,000 earned income - $12,400 standard deduction). Since she is kiddie tax–exempt, her federal income tax bill is only $640 (10 percent of $6,400). So the earned income eliminated the kiddie tax problem.
5. Your daughter can probably claim the $2,500 American Opportunity tax credit and cut her federal income tax bill to $0, plus get some cash from Uncle Sam for the refundable portion of the credit.
Exploit the Unearned Income Threshold
The kiddie tax applies only when your child has unearned income in excess of the threshold for that year. The thresholds are $2,100 for 2018 and $2,200 for 2019. In later years, the law makes the IRS adjust the threshold for inflation. The threshold gives you some room to work with.
Pick the Right Investments
Even when the child owns a significant amount of investment assets, you can often avoid the kiddie tax or keep it to a bare minimum by picking the right investments. For example:
Invest your child’s money in growth stocks with minimal turnover. That way, there usually won’t be much unearned income because most growth companies pay only modest dividends or no dividends at all. Dividends and gains up to the unearned income threshold ($2,200 for 2019) won’t be hit with the kiddie tax.
If your child’s dividends and gains are poised to significantly exceed the unearned income threshold, your child may be able to sell some loser stocks to trigger capital losses in order to get back near the threshold or below it— thus avoiding any significant kiddie tax hit.
In summary, following a buy-and-hold strategy with growth stocks until a year when your child is kiddie tax–exempt should result in most or all of the dividends and eventual long-term capital gains being taxed at your child’s low rates (probably 0 percent).
Tax-Efficient Mutual Funds
Use a buy-and-hold strategy with tax-efficient mutual funds. The mutual funds can minimize or avoid the kiddie tax threat in essentially the same fashion as investing in growth stocks.
Series EE US Savings Bonds
Your child can own a substantial amount of Series EE US savings bonds and never pay a dime of kiddie tax on the interest income they produce. Why? Because the accumulated interest income is tax-deferred until the bonds are cashed in.
If the cash-in date is put off until a year when your child is kiddie tax–exempt, there won’t be any kiddie tax on the interest. Instead it will be taxed at your child’s presumably low rate. As a bonus, US savings bond interest is exempt from state income tax.
Section 529 Plan
Qualified withdrawals from a Section 529 plan account are federal income tax–free.
As long as withdrawals are tax-free, there are no kiddie tax worries even when your child owns the account.
But the 529 plan advantage can disappear if withdrawals are not actually tax-free. Withdrawals are tax-free only to the extent of qualified higher education expenses (and K-12 expenses of up to $10,000 per year if the plan so allows) paid in the same year as the withdrawals.
You must reduce qualified expenses by the amount of tax-free scholarships received by your child and by any amounts used to claim the American Opportunity or Lifetime Learning tax credit. The earnings portion of a withdrawal taken in a year without offsetting qualified education expenses is taxed at ordinary income rates and is generally hit with a 10 percent penalty tax to boot.7
Paying Your Kids Through Your Dental Practice - Summary
Your dependent child or young adult faces no kiddie tax problems if he or she does not have unearned income in excess of the kiddie tax unearned income threshold ($2,100 for 2018 and $2,200 for 2019).
And when a dentist’s dependent child exceeds the threshold by only a minor amount, the kiddie tax hit is minimal, but if your child is getting hit hard by the kiddie tax, your tax planning should consider the following:
- employing your child through your dental practice so that he or she has earned income sufficient to eliminate the kiddie tax, or
- changing the investment mix from income generation to capital growth.
Feel free to email us with any questions you have about paying your child through your dental practice.
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Dental CPA’s – Design By Results
Greig Davis CPA CPV MST – Dental CPA