Money and Taxes for Tweens and Teens in a Microbusiness | Business
Does a CEO Kid Owe Taxes?
Did your CEO kid earn money this year by running a business, babysitting, mowing grass or buying and selling on eBay? If so, he or she will probably have to pay taxes on the profit. Unfortunately, the US tax system does not give any tax breaks to young entrepreneurs.
Federal Income Tax for Young Entrepreneurs
Every business owner in America pays at least two types of taxes: federal income tax and self- employment tax. There are other types of taxes including sales tax and state income tax, but federal income tax and self-employment tax are the two largest.
If your CEO kid made $5,950 or more in 2012, he or she will need to pay federal income tax. This income can come from being an employee or the profit from owning a business. The amount below $5,950 is not taxed, because it is the amount of the standard deduction for a single person. It is adjusted by a few hundred dollars every year.
Parents should not add their child’s income to their tax return. A child files a separate tax return. Parents can still claim their child as a dependent even when the child files a separate tax return.
Americans report their income and tax due on a Form 1040 and business owners report their profit on a form called Schedule C Profit or Loss from Business and attach it to the Form 1040. This is true for CEO kids too.
On the Schedule C, a business owner lists all his income and expenses by certain categories that the IRS picked out. You may notice that these categories may not fit your child’s business. For example, there is no category for internet fees. A CPA (Certified Public Accountant) can be very helpful in sorting out your records and filling out the Schedule C correctly. I put an example of a teenager’s Schedule C in my book Teens and Taxes: A Guide for Parents and Teenagers available at TeensAndTaxes.com.
The “bottom line” on the Schedule C is the profit, or what the IRS calls net income. That amount is what gets taxed.
The Hidden Tax for Business Owners
You probably know about federal income tax, but you may not be aware of another tax on the Form 1040, called the self-employment tax (or SE tax). SE tax is Social Security and Medicare taxes for self-employed people and business owners. The SE tax rate is 15.3% of a business’ profit. If a CEO kid has a profit of $400 or more, he or she will owe self-employment tax. The $400 threshold is quite low, and unfortunately, has not been adjusted in decades. Many young entrepreneurs who have a business find that they may not owe federal income tax, but they will owe self-employment tax (at 15.3% of their profits)!!
For example, Tom is a teenager with a nice-sized profit of $7,000 in 2012 from his business. Tom will owe $56 in federal income tax. Not too bad a price to pay for $7,000 profit. But Tom also will owe $989 in self-employment tax. He owes more in self-employment tax than in federal income tax!
I call the self-employment tax a hidden tax because many new business owners do not know about it and it is buried in the middle of the back page on the Form 1040 and is easy to miss.
How to Reduce Taxes
It may seem like a lot of your child’s hard-earned money is going to taxes. The best way to reduce taxes low is to keep good records of all business expenses, plan ahead, and work closely with a CPA who can advise you.
If your son or daughter earned money by working in or around a customer’s home such as babysitting or mowing grass, there might be a special tax break for them. They may be what the IRS calls a ‘household employee’ and may not have to pay self-employment tax. This can be a huge tax savings. Visit TeensAndTaxes.com for details or ask your CPA to explain household employee status.
Carol Topp, CPA (TeensAndTaxes.com and MicroBusinessForTeens.com) is the author of Money and Taxes in a Micro Business, part of the Micro Business for Teens series. Her goal is to make taxes and accounting easy to understand through her websites, books and webinars.