Month: June 2018

Summer jobs can be an effective way to teach children about financial responsibility, encourage them to save for college or retirement, and provide them with spending money during the school year. If you own a business, consider hiring your child (or grandchild) as a legitimate employee. It can be a smart tax-saving strategy for employee and employer alike, especially under the Tax Cuts and Jobs Act (TCJA).

Tax Advantages

When you hire your child, you get a business tax deduction for employee wage expenses. In turn, the deduction reduces your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable).

Your child’s wages are also exempt from Social Security, Medicare, and FUTA taxes, if the following conditions are met:

• Your business operates as a sole proprietorship, a single-member limited liability company (LLC) that’s treated as a sole proprietorship for tax purposes, a husband-wife partnership or an LLC that is treated as a husband-wife partnership.
• Your child is under age 18 (or under age 21 in the case of the FUTA tax exemption).
• Your child is a legitimate part-time or full-time employee of the business.

Unfortunately, corporations aren’t eligible for this break. (See “Corporate Employers Don’t Get Payroll Tax Break” at right.)

Thanks to the TCJA, your employee-child can use his or her standard deduction to shelter up to $12,000 of 2018 wages paid by your business from the federal income tax. For 2017, the standard deduction was only $6,350. But the TCJA nearly doubled it for 2018 through 2025. That makes the hiring-your-kid strategy better than before.

Important note: For an unmarried dependent child with earned income, the 2018 standard deduction is the greater of 1) $1,050 or 2) earned income + $350 but no more than $12,000.

In other words, for 2018, your child will owe nothing in federal taxes on the first $12,000 of wages, unless he or she has income from other sources. Your child can save some of the wages — and possibly even contribute money to a Roth IRA or put it into a college fund.

The Roth Angle

The only tax-law requirement for your child to make annual Roth IRA contributions is having earned income for the year that at least equals what’s contributed for that year. Age is completely irrelevant. So, if your child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year.

For the 2018 tax year, a working child can contribute the lesser of:

• His or her earned income, or
• $5,500.

While the same $5,500 contribution limit applies equally to Roth IRAs and traditional deductible IRAs, the Roth option usually makes more sense for young people. Why? Your child can withdraw all or part of the annual Roth contributions — without any federal income tax or penalty — to pay for college or for any other reason. However, Roth earnings generally can’t be withdrawn tax-free before age 59½.

In contrast, if your child makes deductible contributions to a traditional IRA, any subsequent withdrawals must be included in gross income. Even worse, traditional IRA withdrawals taken before age 59½ will be hit with a 10% early withdrawal penalty tax unless an exception applies. (One exception is to pay for qualified higher-education expenses.)

Important note: Even though your child can withdraw Roth contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the Roth account balance as possible untouched until retirement (or later) in order to accumulate a larger federal-income-tax-free sum.

Modest Contributions Can Add Up

By making Roth contributions for just a few teenage years, your child can potentially accumulate a significant nest egg by retirement age. Realistically, however, most kids won’t be willing to contribute the $5,500 annual maximum even when they have enough earnings to do so.

If you can talk your teenager into contributing a meaningful amount toward retirement — rather than buying clothes at the mall, concert tickets or V-Bucks to spend on Fortnite (the latest video game fad) — here’s what could happen.

Tommy the Teenager contributes $1,000 to a Roth IRA at the end of each year for four years (ages 15 through 18). Assuming a 5% annual rate of return, the Roth account would be worth about $33,000 in 45 years when the “kid” is 60 years old. If you assume a more-optimistic 8% return, the account would be worth about $114,000 in 45 years.

If Tommy’s parent could talk him into contributing $2,500 each year, his Roth account would be worth a whopping $285,000, assuming an 8% rate of return.

Tax Deductions for Traditional IRA Contributions

Aren’t the tax deductions for traditional IRA contributions an advantage compared to contributing to Roth IRAs? While it’s true that there are no write-offs for Roth contributions, your child probably won’t get any meaningful tax breaks from contributing to a traditional IRA either. That’s because an unmarried dependent child’s standard deduction will automatically shelter up to $12,000 of 2018 earned income from federal income tax. Plus, any additional income will almost certainly be taxed at very low rates.

So, unless the child has enough taxable income to owe a significant amount of tax, the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that’s the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top.

Tax-Savvy Parents Raise Tax-Savvy Kids

Hiring your child can be a tax-smart idea. Remember, however, that the child’s wages must be reasonable for the work performed. So, this strategy works best with teenage children whom you can assign meaningful tasks to. Keep the same records as for any other employee to substantiate hours worked and duties performed (such as timesheets and job descriptions), and issue your child a Form W-2, as you would for any other employee.

Encouraging your child to make Roth IRA contributions is a great way to introduce the ideas of saving money and investing for the future. It’s also a great lesson in tax planning. It’s never too soon for children to learn about taxes and how to legally minimize or avoid them.

Many state legislatures are now in session. A major issue that state lawmakers may currently face is whether to conform their state income tax systems to all the changes included in the Tax Cuts and Jobs Act (TCJA). Some states are considering or have adopted legislation to address the following key provisions of the new tax law.

Beyond SALT

The media has given a lot of attention to certain provisions in the TCJA, such as the new limit on federal income tax itemized deductions for personal state and local taxes (SALT). For 2018 through 2025, the maximum deduction for the combined total of state and local income and property taxes is $10,000, or $5,000 for married people who elect to file separately. This new federal limit has put pressure on some states to reduce residents’ state income tax burdens or find ways to work around the rules.

But the bigger issue is whether states will conform with all the other changes made by the TCJA. Many states “piggyback” their state personal and corporate income tax rules on the federal rules to simplify filing your state income taxes. But when big changes are made to the federal rules, as happened with the TCJA, state legislatures must decide whether to conform or “decouple.” (See “Traditional Approaches to State Tax Conformity” at right.)

TCJA Provisions that Could Potentially Reduce State Tax Collections

Several TCJA changes threaten to reduce state taxable income and result in lower tax collections for the state — unless the state decouples from the changes. Examples of pro-taxpayer TCJA provisions that states must decide whether to conform to (thereby reducing the state’s tax base) or decouple from (thereby maintaining the state’s tax base) include:

Bigger standard deductions. Many states base the state taxable income of individual taxpayers on federal taxable income. The TCJA almost doubled the federal standard deductions, causing federal taxable income to decrease for many taxpayers.

Elimination of itemized deduction phaseout rule. Under prior law, up to 80% of the most popular federal itemized deductions — for mortgage interest, state and local taxes, and charitable donations — could be phased out for high-income taxpayers. If state taxable income is based on federal taxable income, this phaseout rule increased state taxable income and thereby created more tax revenue for the state. For 2018 through 2015, the TCJA eliminates the itemized deduction phaseout rule.

Higher gift and estate tax exemption. For 2018 through 2025, the TCJA essentially doubles the unified federal gift and estate tax exemption. For 2018, the exemption is a whopping $11.18 million or effectively $22.36 million for a married couple. Several states and the District of Columbia tie their state death tax exemptions to the federal exemption.

Liberalized rule for Section 529 plans. The TCJA liberalizes the Sec. 529 plan rules to allow federal-income-tax-free withdrawals of up to $10,000 a year to cover tuition at a public, private, or religious elementary or secondary school. This change is permanent, for qualifying withdrawals made after December 31, 2017.

Deduction for pass-through business income. For 2018 through 2025, the TCJA allows individual taxpayers to claim a deduction for up to 20% of qualified business income (QBI) from so-called “pass-through” businesses. This includes sole proprietorships, partnerships, S corporations and limited liability companies (LLCs) treated as sole proprietorships or partnerships for tax purposes. Limitations apply at higher income levels.

First-year expensing and depreciation for business assets. Under the TCJA, for qualifying property placed in service in tax years beginning after December 31, 2017, the maximum Section 179 deduction is increased to $1 million (up from $510,000 for tax years beginning in 2017), with inflation adjustments after 2018.

Under the TCJA, 100% first-year bonus depreciation is also allowed for qualified property generally placed in service between September 28, 2017, and December 31, 2022. Bonus depreciation is now allowed for both new and used qualifying property.

TCJA Provisions that Could Potentially Boost State Tax Collections

Not all TCJA provisions are taxpayer friendly. Some changes will generate additional federal taxable income and, for states that conform to the changes, additional state income tax revenue. Examples include:

Elimination of personal and dependent exemption deductions. For 2018 through 2025, the TCJA eliminates exemption deductions. Quite a few states are affected by this change, because the number of exemptions they allow a taxpayer to claim for state income tax purposes is tied to the number of exemptions claimed on the federal return.

New limits on business interest deductions. Under the TCJA, affected corporate and noncorporate businesses generally can’t deduct interest expense in excess of 30% of “adjusted taxable income,” starting with tax years beginning after December 31, 2017. For tax years beginning in 2018 through 2021, adjusted taxable income is calculated by adding back allowable deductions for depreciation, amortization and depletion. After that, these amounts aren’t added back in calculating adjusted taxable income.

Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that can’t be deducted in the current year can generally be carried forward indefinitely. Small and medium-size businesses and certain real estate and farming ventures are exempt from this anti-taxpayer change.

Reduced or eliminated business deductions for business meals and entertainment. Under the TCJA, deductions for most business-related entertainment expenses are disallowed for amounts paid or incurred after December 31, 2017. Meal expenses incurred while traveling on business are still 50% deductible, but the 50% disallowance rule now also applies to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises will be nondeductible.

Eliminated deductions for certain employee fringe benefits.The TCJA disallows employer deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety. The law also eliminates employer deductions for the cost of providing qualified employee transportation fringe benefits (for example, parking, mass transit passes and van pooling).

Wait and See

As these examples show, state legislatures have plenty of tax conformity issues to consider this year. Both individual taxpayers and businesses will be affected by tax conformity outcomes. Your tax advisor is atop the latest developments and, as your state tackles these issues, can help determine how you, your family and your business will be affected.

 

Traditional Approaches to State Tax Conformity

In many states, the calculation of state taxable income for individual taxpayers starts with their federal adjusted gross income (AGI).

To Adjust or Not to Adjust?

Federal AGI includes all federal taxable income items and certain write-offs, such as:

• Self-employed retirement plan contributions,
• Deductible IRA contributions,
• HSA contributions,
• Student loan interest, and
• Alimony payments.

From there, states may allow their own exemptions and deductions. They also may mandate other adjustments to arrive at state taxable income.

However, some states conform more closely by mirroring federal exemptions and deductions all the way to the state taxable income amount.

How to React to Changes?

States also have different procedures for reacting to federal tax law changes. Some automatically conform to all federal changes unless the state legislature specifically decouples from certain changes. Other states follow the federal rules that are in effect for a particular year and must adopt any changes to those rules.

However, these approaches to conformity are generalizations, because no two states conform (or decouple) in exactly the same way. For example, a few states allow you to deduct your federal income tax payments in calculating your state taxable income, but most don’t. Some states require you to add back any federal itemized deduction for state income taxes, but others don’t. Some states give you a credit for a percentage of your state and local property tax bills, but most don’t. Some states adjust their tax brackets every year to conform to the federal tax bracket inflation adjustments, but some don’t. The differences go on and on.

Conformity issues also exist for business state income tax returns. For example, some states haven’t allowed previous increases to the federal Section 179 first-year depreciation allowance.

Differences in tax rules across state lines add complexity to filing personal and business tax returns, especially for individuals and businesses that earn income in more than one state or move during a tax year.