IRS clarifies payroll tax rules for children

The IRS recently issued temporary tax regulations that clarify the payroll tax treatment of children employed by “disregarded entities” owned by a parent. This guidance makes it easier for parents to employ their children within a separate legal entity.

The background on this issue is a statutory rule that exempts wages paid to a child by his or her parent from FICA and FUTA taxes. FICA is often called “social security” taxes, and includes a 6.2 percent OASDI and a 1.45 percent Medicare tax. FUTA is federal unemployment tax.

Since both the employer and employee pay FICA, it can consume 15.3 percent of an employee’s wages. Many students who are working do not make enough to pay income tax, but they do pay their 7.65 percent share of FICA tax.

If the child works directly for a parent, FICA tax is avoided if the child is under age 18 and FUTA is avoided if the child is under age 21. To qualify for this exemption, the child must work for the parent, and not for a separate entity, such as a corporation, owned by the parent.

Almost 15 years ago regulations were issued that permit a limited liability company (LLC) owned by one member to report as if the entity did not exist for tax purposes. Such an LLC is called a “disregarded entity,” and all operations are simply reported on the owner’s tax return.

After some reflection, the IRS decided that it wanted a DE to report as a separate entity for payroll tax purposes. So DEs were required to obtain their own tax ID number and to report as if they were corporations for payroll tax purposes.

This payroll tax status called into question the treatment of a child employed by a parent’s DE. Although the DE was ignored for income tax purposes, it’s recognition for payroll tax suggested that the parent would lose the FICA/FUTA exemptions for wages paid from the DE to the sole member’s child.

IRS now clarifies that for purposes of applying the parent-child employment exemption, a DE owned by the parent will be ignored. So while payroll taxes must be withheld and reported by the DE for other employees, payments made to the owner’s child can escape payroll taxes.

This regulation is effective for wages paid after Oct. 31, 2011, but may also be applied to any wages paid after 2008. So any parent who employed a qualifying child in a DE and previously paid FICA and FUTA may apply for a refund of post-2008 payments.

Q: I bought a rental condo in Arizona in a short sale, and financed the $78,000 cost by a home equity loan on my residence. When I do my taxes, I want to deduct the interest on schedule E to reduce my AGI. Must I report this on schedule A because the loan is on my house?

A: Generally yes, but you may elect an alternate treatment. Most interest is classified by “tracing” the proceeds to a particular use. The one exception is debt secured by a residence. Such debt is classified by its security (as residence interest) rather than the use of the loan proceeds.

A loan secured by a residence that is used to acquire, construct or substantially improve that residence is deducted on schedule A. A loan secured by the residence that is used for other purposes is also deductible on schedule A to the extent the loan principal does not exceed $100,000.

The residence interest rules allow an election to disregard the residence interest classification, and therefore return to the general rule that the interest is classified by tracing the proceeds.

The election may be made by attaching a statement to your return referencing Regulation Section 1.163-10T(o)(5). Once made, the election applies to all future years.

Also keep in mind that your Arizona rental will be a “passive activity” and if the interest creates or increases a rental loss the loss may be limited by the passive loss rules.

There is a $25,000 “active” rental exception to the passive loss limits that may apply to your facts, but you should make sure that your interest will not get caught in the passive loss trap before making the election.

James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at

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