Kids and Taxes

Most kids who start their own business do so because they want to make some extra money, maybe so they can buy a car or save for college or just for some extra spending money.  I’m going to go out on a limb here and assume that the last thing kids are thinking about when they start a business is the taxes they will owe on any profits they earn.

However, as self employed people, taxes could be one of their biggest expenses.  Self employed people are subject not only to federal income taxes, but to self employment taxes as well.  As a result, this can be the biggest expense for a self employed person, and can be quite a shock if you’re not prepared for it.

What is self employment tax?  Basically, self employment tax represents Social Security and Medicare taxes for people who work for themselves. This tax is used to fund benefits you receive when you retire (old age and hospital insurance). It is also used to pay benefits if you become disabled, or to your family in the event of your premature death (disability and survivor insurance).

Self employment tax is similar to the payroll taxes withheld from the pay of most employees. The biggest difference is that as a business owner, you are required to pay both the employee and the employerís share of the Social Security and Medicare taxes.  So while employees of a company pay 7.65%, self employed people pay 15.3% in Social Security and Medicare taxes.

Even worse, this tax is on top of your regular income tax.  So if you are in the 10% tax bracket (we’ll assume no state income tax for this example), your taxes on your profit from your business could be over 25% (15.3% self employment tax plus 10% federal income tax).

When do you pay this tax?  The federal income tax system is a pay-as-you-go tax system. That means you pay taxes as you earn income throughout the year. If you are an employee of a company, you do this through withholding. If you are self employed, you do this through estimated tax payments.

The general rule is that you must make estimated tax payments if you expect to owe at least $1,000 in tax for the current tax year, after subtracting your withholding and tax credits.  Estimated tax payments are due on April 15, June 15, September 15 and January 15 of each year (or the next day if the 15th falls on a weekend or holiday).  Failing to make estimated tax payments on time could result in a penalty even if you are due a refund when you file your tax return.

Even if you don’t have to make estimated tax payments, it’s a good idea to set aside 20-30% of your net profits (depending on what tax bracket you fall into) so that you will have enough to pay your taxes when it’s time to file your tax return.

Parents: want to learn how to minimize your family’s taxes?  If you have a small business, or if your child has their own business, you’ll want to learn how to hire your children (insert affiliate link) to help minimize your family’s tax burden.

Kristine A. McKinley, CPA, and CFPÆ, offers financial and tax planning on an hourly, fee-only basis. She specializes in helping home based and online business owners understand and minimize their income taxes so they can keep more of their profits.  Link to tax blog: www.internetbiztaxtips.com

If you have kids who are in business for themselves, then just like adults, they may need to make estimated tax payments.  Here’s a brief summary of who needs to make estimated tax payments and how to make them.

The federal income tax system is a pay-as-you-go tax system.  That means you pay taxes as you earn income throughout the year.  If you are an employee of a company, you do this through withholding.  If you are self employed, you do this through estimated tax payments.

The general rule is that you must make estimated tax payments if you expect to owe at least $1,000 in tax for the current tax year, after subtracting your withholding and tax credits (such as the Earned Income Credit or Retirement Savings Credit).

Also if you havenít paid in at least…

*  90% of the tax due on your current year tax return, or
*  100% of the tax due on last yearís tax return

then you may need to make estimated tax payments.

Generally, you will estimate your tax liability for the entire year and divide that amount by four to determine your quarterly estimated tax payments.  The IRS has calculators on their website to help with this.

The due dates for estimated tax payments are:

April 15
June 15
September 15
January 15 the next year

If any of these fall on the weekend or a holiday, then your payment is due on the next business day.

Form 1040-ES is used to make estimated tax payments.

One note regarding estimated tax payments:  if the person who owes estimated tax payments has other income from an employer, they can increase the withholding from the other income source to avoid having to make estimated tax payments.  For example, if Tommy expects to owe taxes because of his lawn mowing business, but he has another job when he’s not mowing lawns, he can ask his employer to increase his taxes from his job so he doesn’t have to make estimated tax payments on the income he earns mowing lawns.

Parents: want to learn how to minimize your family’s taxes?  If you have a small business, or if your child has their own business, you’ll want to learn how to hire your children (insert affiliate link) to help minimize your family’s tax burden.

Kristine A. McKinley, CPA, and CFPÆ, offers financial and tax planning on an hourly, fee-only basis. She specializes in helping home based and online business owners understand and minimize their income taxes so they can keep more of their profits.  Link to tax blog: www.internetbiztaxtips.com

The IRS has different tax rules for kids, so how do you know if your child is required to file a tax return?

In general, kids who are dependents (claimed on someone else’s tax return) must file a tax return if:

- they have earned income of $5,700 or higher (this is the standard deduction amount for 2009, the amount for 2008 was $5,450)
- they have unearned income (investment income) of $950 in 2009 ($900 in 2008)
- they have gross income (both earned and unearned) in excess of the larger of $950 or their earned income plus $300.

The most common reason kids would need to file a tax return is because they had earned income from a part time job or because they are lucky enough to have investments in their own name, as described in the above rules.  However, the following children may also be required to file a tax return:

- those who have earned income and who received advanced earned income credit payments from his or her employer,
- kids who had wages of $108.28 or more from a church, that is exempt from employer Social Security and Medicare taxes, or
- kids who had net earnings from self employment or their own business of at least $400.

Example:  Sarah is 15 and is claimed as a dependent on her parents’ tax return.  In 2008, her only income was $250 she earned from making jewelry and selling it to her family and friends.  In 2008, she is not required to file a tax return.  However, let’s assume that word about her jewelry spread and in 2009 she doubled her income.  Assuming her net earnings (after expenses) from her jewelry business was $500, she would be required to file a 2009 income tax return.

Filing your child’s tax return:

If your child is required to file only because he or she had investment income, you may be able to report the child’s income on the parent’s tax return, which would eliminate the need to file two tax returns.

If the child is required to file because she has earned income from an employer, or if she has a business of her own, then she will need to file her own tax return.  In addition, children with their own businesses will need to complete Schedule C – Profit or Loss From Business and Schedule SE – Self Employment Tax and attach these to their income tax return.