By Eric Rosenberg, WCI Contributor
Many parents who own businesses are interested in hiring their children as employees. This decision has clear advantages, including spending more time with your child, helping them develop their work ethic, and showing them the ropes of the family business. But the reason many parents consider this option is for taxes.
If your dependent child earns less than the standard deduction for that year, you can deduct their salary from your income as a business expense and avoid paying federal income tax. Also, some business entities (non-corporations) are exempt from paying Social Security and Medicare (FICA) taxes and federal unemployment (FUTA) taxes when employing a minor child.
Here’s a closer look at the potential tax benefits of hiring your child and other financial details to consider when putting your kids on the payroll. It could benefit you while benefitting them at the same time.
Why Do People Hire Their Children?
There are plenty of reasons to hire your child. Beyond gaining valuable experience early in their lives, turning your income into your child’s income can save your household money during tax season.
Federal Income Tax Savings
If you’re a business owner in a high tax bracket, hiring your child is a legal method of reducing your family’s taxable income. The wages you pay your child won’t be liable to federal income tax unless they earn more than the annual standard deduction. In 2023, the standard deduction is $13,850, meaning your minor child could earn about $1,150 monthly and not be subject to income taxes.
If your child earns more than the standard deduction, they’ll only owe taxes on wages above the standard deduction threshold. Here are the tax rates for a single filer for 2023:
For example, if your child earns $15,000 in one year, they’ll have earned $13,850 exempt from the federal income tax and have to pay a low tax rate on the additional $1,150 they earned.
Payroll Tax Advantages (FICA and FUTA taxes)
Suppose the parent’s business entity is a sole proprietorship, single-member LLC, or partnership, and they are the sole owner. In that case, they won’t have to pay Social Security or Medicare (FICA) taxes for a child employee under the age of 18. Similarly, payment for work done by your child under age 21 is exempt from federal unemployment (FUTA) taxes.
These advantages are only for an unincorporated business entity. Corporations, including S Corporations, do not qualify for payroll tax exemptions. Still, with savings on their federal income taxes, parents who own a corporation might find it financially beneficial to make their kids employees. Plus, you may be able to get around that corporation rule by having your corporation contract with a separate sole proprietorship that actually hires your kids, but this is getting into a gray area.
A child employee’s wages may still be subject to federal withholdings, even if they’re not subject to FICA or FUTA taxes. They should still receive a W-2 from your business.
Retirement Contributions for Your Kids
As a parent, you can decide where your child’s income goes until they turn 18. Or longer, if you lay on the guilt. You can funnel your kids' paychecks into Roth IRA accounts up to annual contribution limits [$6,500 in 2023]. This strategy starts them on track to a nice retirement with at least 40-60 years for their investments to grow before they’re needed.
Savvy investors know the power of compound investing. Starting your kids' longest-term investment accounts when they’re young is an excellent way to help them start with a strong financial foundation. Even if your child isn't interested in using their hard-earned cash for retirement at the moment, money is fungible. You can “match” their earnings, giving them what they earn as a gift while putting the earnings into the Roth IRA.
More information here:
Rules You Should Follow
If you’re interested in hiring your child as an employee, there are specific rules you’ll need to follow to ensure you get all the possible deductions.
Your child's job needs to be considered legitimate work by the IRS. A good rule to follow is that if they’re not doing tasks that a non-relative would be considered an employee for doing, they likely don’t qualify as an employee.
For example, you wouldn’t call someone an employee for spending 10 minutes once a week wiping down your desk. The work they do needs to be something an average employee would do, though it doesn’t need to be beyond a child's or teenager's abilities. Their tasks should be standard, helpful, and routine for your business.
Pay your child in proportion to the work they do. Tax incentives encourage parents to transfer as much money as possible to their kids, but the IRS knows this and is watching for it.
If you try paying your child $1,000 per hour to sort files for you, you’ll risk losing all your tax advantages with your child. If you’re struggling to decide how much is a reasonable wage, find comparable businesses and see what they pay for similar work. You can use your other employees’ salaries as a reference point if you own your practice.
Keep Payment Records
The best way to pay your child for their work is with direct deposit or a check given at regular intervals. Paying your child in cash may arouse suspicion as it’s harder to track. Keeping a timesheet listing the hours your child worked and their specific tasks will streamline your interactions with the IRS.
Remember that you can deposit your child’s money into a traditional bank account or an investment account like a Roth IRA.
Required paperwork for employees includes:
- Form I-9 (one time)
- Form W-4 (one time)
- Employment contract (at least one time)
- Timecard showing hours worked (at least annual)
- Form W-2 (annual)
- Form W-3 (annual)
No Personal Services
You can’t pay your child for personal services. Their wages must be paid in exchange for work done in a business setting. Paying your child to make smoothies wouldn’t be deductible from your business income (unless you run a smoothie business; then it could be allowed).
As a medical professional, something related to your work or office is the easiest to prove to the IRS, should you ever encounter an audit.
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What Is the Kiddie Tax?
The “Kiddie Tax” closes a loophole where parents side-step income taxes by gifting their children income-producing assets. The tax, as it exists today, applies to unearned income. If you hire your child to work, their wages will count as earned income and won’t be subject to the Kiddie Tax.
It’s important to remember that the exemptions and advantages apply only to federal taxes. Your state may require you to meet different criteria to be exempt from state taxes. For example, your sole proprietorship could be exempt from FUTA taxes for an employee under 21 but still be subject to state unemployment taxes.
This also applies to child labor laws. The Fair Labor Standards Act (FLSA) is the bedrock for federal child labor protections in the US. It holds that children under 14 can’t work and limits how many hours kids between 14 and 15 can be employed. The FLSA doesn’t have age or hour restrictions for children hired by their parents, with the condition that the business entity is owned solely by them.
State restrictions can be different, though, and they could require a minimum age or could restrict certain types of work. For example, kids in Texas can’t work in roofing or with woodworking machines. You must comply with these state and local laws to hire your children legally.
More information here:
The Bottom Line
Hiring your child can be a savvy way to move your business income into a lower federal income tax bracket. Some unincorporated business entities owned solely by a child’s parents can also avoid responsibility for FICA and FUTA payroll taxes. To take advantage of these tax benefits, your child must do legitimate work, and you must pay them a reasonable amount. If you add your child to the payroll, keep detailed records of your child’s work and how much you pay them. That way, your kids and your business can benefit from the labor they produce.
If you need help with tax preparation or you’re looking for tips on the best tax strategies, hire a WCI-vetted professional to help you figure it out.
Have you used your children as employees for your business? Has it lowered your tax burden? Has it taught them about the world of taxes? Comment below!