By Jason Watson, CPA
Posted February 22, 2020
As mentioned in other areas of this book, your family might benefit from adding children and / or parents to your entity. For example, you could have your children be 10% owners each. They in turn pay very little tax compared to you, and they can either gift the money back to you (good luck) or you can surrender and use this ownership method as a conduit to give them your money which is going to happen anyway.
For example, they are 25 years old making $50,000 on their own. Your business had net profits of $250,000. Because of exemptions and deductions, your child is in the 10% marginal tax rate whereas you are in the 22% marginal tax rate. Not a huge swing, but you get the idea.
Other examples include minor children. Yes, a minor can own shares in an S corporation. However, given kiddie tax rates (even with the recent SECURE Act) this might not be beneficial since your child could be taxed at your rate. What if the minor child materially participates in the corporation. Huh?
There are seven tests for material participation, and the easiest one is 500 hours per year (or about 10 hours a week). The activity must also be regular, continuous and substantial (this is straight out of the ATG – Audit Techniques Guide from the IRS). So, if you nail down the material participation with your minor children, they can earn income and be taxed at their own tax rate as opposed to your tax rate. Yes, they can gift the money back to you or make a contribution to their retirement accounts. We prefer the former.
Wait! There’s more. You can still claim them as a dependent if you provide over half of their support. How expensive are kids? Really expensive!
Your Mom and Dad can qualify for this as well. And if you are an S Corp, you don’t have to pay a salary to shareholders who do not materially participate in the business activities (inactive shareholders). In other words, you could siphon income and distributions off to Mom, and they will be taxed at her income tax rate.
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