Hire Your Child, Save Big on Taxes

Owning a business is a stressful endeavor that can be rewarding, both financially and emotionally.

One major benefit of running your own business is that you can kick-start your child’s career by hiring them in your business.

This will allow your child to develop important skills at an early age. It will also allow your child the opportunity to learn personal finance by saving for a big purchase or college.

Even better, your child can start building a ROTH IRA account and have a monster account balance by the time they turn 18.

What’s in it for you?

Well, you get to work with someone you love and trust and you get to expose them to unique opportunities to shape their mindset from an early age.

And there are tax benefits. Sweet, sweet tax benefits.

Basic Tax Benefits of Hiring Your Child

Let’s start with the basic concept.

When you hire your child, your business receives a tax deduction for the ordinary and necessary expense. Business expenses reduce tax liability.

Why?

If you have $10,000 of net profit and you’re in the 37% tax bracket, you’ll pay $3,700 in taxes. But if you have $6,000 in net profit, you’ll pay $2,220 in taxes.

The $4,000 expense in the above example technically saved you $1,480 in taxes.

Let’s assume you pay your child $10,000 to work in your business and you’re in the 37% tax bracket. Because this business expense will reduce your net profit by $10,000, it will also save you $3,700 in taxes.

Additionally, because every taxpayer (including your children) are able to claim the standard deduction of $12,550 (in 2021), your child will pay $0 in taxes on their $10,000 in earnings.

By shifting your income to your child, you create a tax benefit (the tax savings) of $3,700 and your child gets $10,000 in tax-free earnings thanks to the standard deduction fully offsetting their income.

The government literally paid you $3,700 to hire your child.

Sweet deal, but it gets better.

Avoiding the 15.3% FICA Tax

Sole proprietors, single-member LLCs, and partnership LLCs (but not corporations) where both parents are the only partners/owners of the business are not required to pay Social Security and Medicare (FICA) taxes when employing a child under 18 years of age.

On that same $10,000 payment in our prior example, your business saves $1,530 in FICA taxes as well as the $3,700 in income taxes.

Paying your child $10,000 in this example saves you a total of $5,230 in taxes.

And that’s before applying any savings from state taxes.

Note: if you pay your child on a 1099 basis, you will have to pay SE taxes. You only avoid FICA taxes when paying compensation through payroll.

Paying Your Child More Than the Standard Deduction

It is possible to pay your child more than the standard deduction and still allow the child to avoid income taxes on the payment.

In 2021, the annual contribution limit for an IRA is $6,000.

If the standard deduction is $12,550, then you can pay your child a total of $18,550 without subjecting them to tax. They would contribute $6,000 to a traditional IRA which would drop their income down to $12,550 and that would then be eliminated by the standard deduction.

Paying your child $18,550 will save you $6,864 in income taxes (37% rate) plus $2,838 in FICA taxes (15.3% rate) for a total of $9,702 in tax savings.

What About the Kiddie Tax?

The kiddie tax applies to unearned income. Through this article, we have been talking about earned income. This is described in IRC Sec. 1(g).

Unearned income is interest, dividends, capital gains, and distributions from inherited IRAs, 401(k)s, and trusts.

Income generated from employment is earned income and not subject to the kiddie tax rules.

How Young Can Your Child-Employee Be?

Under the Fair Labor Standards Act (FLSA) there are four tiers covering non-farm employment of children:

• <14 years of age
• 14-15 years of age
• 16-17 years of age
• >18 years of age

Children in the first tier, being less than 14 years of age, are not allowed to perform any non-farm work for any number of hours. There are a handful of exceptions for those delivering newspapers, babysitting, and working as an actor or model.

Children in the second tier, ages 14-15, can work but are limited to the number of hours per day and week and what types of jobs they are allowed to work.

Children in the third tier can work as many hours as they’d like, whenever they’d like but are not allowed to work “hazardous” jobs.

And children in the last tier, ages 18+, are treated as adults and do not have restrictions.

But, there’s an exception to the above limitations.

If a business is solely owned by the child’s parents, meaning the parents individually or collectively own 100% of the company employing the child, then the child is exempt from the above FLSA rules (as long as the parent business is not mining, manufacturing, or hazardous).

That said, the FLSA applies at the federal level. Your state may treat the employment of children differently, so check local laws first.

So how young is too young to hire your own child in a 100% parent-owned business?

Technically, there is no age minimum.

In Eller v. Commissioner, 77 T.C. 934, 862 (1981), the taxpayer employed a 7, 11, and 12 year old. Though the IRS adjusted the payments to the 7-year-old to be “reasonable compensation,” they ultimately allowed the business to deduct the adjusted compensation to the 7-year-old.

Audit Proofing Your Child’s Salary Payment

Now that all the glitz and glam is out of the way, let’s get serious and talk about how you can actually make this work. Because the reality is that many taxpayers mess up paying their children by either not keeping the correct documentation or paying them a salary that is not reasonable.

1. Get an Employer ID. In order to get a business bank account, hire employees, and set up payroll, you’ll need an EIN. You can apply online here.
   
2. Create a job description. A job description allows you to document the role, required experience, performance expectations/responsibilities, and pay.
   
3. Determine reasonable salary. When paying minimum wage, you don’t need to worry about documenting how you determined the salary you are paying your child. But if you are paying significantly over minimum wage, you need to document why you are paying a premium. You can research comparable pay on the Bureau of Labor Statistics. Print your findings to PDF and store them with the rest of your job information for safe keeping.
   • An easy way to think about a “reasonable salary” is to consider what you would pay an unrelated 3rd party to perform the same job. If you’d pay a contractor minimum wage to clear brush from your rental property, you probably shouldn’t pay your child $50/hr for the same job.
   • Many real estate investors make the mistake of thinking that because your child gets a standard deduction of $12,550 that you can pay them that amount and call it “reasonable.” Unfortunately, this logic will not hold up under scrutiny. You must be able to substantiate, with legitimate wage data, why you are paying your children what you are.
     
4. Sign an employment agreement. Have a simple employment agreeemtn drafted up by a local labor attorney. At the same time, have them check your state’s labor laws for compliance issues.
   
5. Require a time sheet. If you are paying anyone on an hourly basis you should require them to produce a time sheet each pay period. However when it comes to your children, you should require a time sheet regardless of whether you pay them hourly or not.
   • In Vernon E. Martens v. Commissioner, 934 F.2d 319 (1991), the taxpayer didn’t have a time log to substantiate the time his sons worked in his business. Thus he lost most of the tax deduction he claimed for the compensation he paid them.
     
6. Set up payroll and issue a W-2 at year-end. When hiring children, you should always pay via W-2 versus 1099. The latter will not held you avoid the 15.3% FICA tax on the compensaiton. Paying in regular intervals, via a legit payroll system, will also create an audit trail that will help you substantiate your child’s job with your company. When using a payroll service, make sure to explain to them that the child is exempt from FICA taxes.
   • Fill out Form I-9 at the beginning of employment. This indicates to the employer that the employee is authorized to work in the U.S.A.
   • Fill out Form W-4 at the beginning of employment. This tells you how many exemptions and allowances you should key into the payroll system for the employee.
   • Complete Form W-2 at the end of the year. This summarizes the employee’s pay. A copy is sent to the employee and to the IRS.
   • Complete Form 941 every quarter. This is a summary of payroll you must complete and file each quarter. States have their own quarterly payroll forms as well.
   • Complete Form 940 at the end of the year. This is required to be filed even though your children, under the age of 21, are exempt from FUTA.

Two Horror Stories

Two tax court cases described below indicate that you should make paying your children very seriously. This is not simply a way to dodge taxes… your child must be working a legitimate job and paid a reasonable salary (and you need to document all of it).

In Ross v. Commissioner, T.C. Summ. Op. 2014-68, the taxpayer paid her children to perform services for her business. However, there was little consistency with how much she paid them and how much they worked. For example, one child earned $4 per hour in 2007 and $10 per hour in 2008, despite working fewer hours in 2008. Another child earned $3.40 per hour in January 2008 but $25 per hour in May 2008.

Additionally, the payments were made to cover the children’s various expenses rather than actual wages. For instance, there were many receipts for “pizza” that the payments were made to the children to cover. The taxpayer testified that it was more convenient for her children to direct her where and when to make payments rather than for her to run payroll.

And of course, the taxpayer did not actually run payroll, did not file employment taxes, and did not file employment returns.

The taxpayer’s deductions for payments to her children were fully denied.

In Fisher v. Commissioner, T.C. Summ. Op. 2016-10, the taxpayer was an attorney and owned her own law firm. She brought her children to the office from time to time to shred papers, send mail, answer phones, and perform other admin-related tasks.

Unfortunately, she did not issue W-2s, keep payroll records, or document anything that would suggest her children were working a legitimate job (i.e. pay determination, timesheets, job description, paystubs, etc). The Tax Court denied all deductions except for $250 per child per year.

Takeaways

Paying your children to work in your business can be a rewarding experience. You get to hire someone you love and trust and provide them with an amazing early-life opportunity.

You can also save big on your taxes. You save your marginal rate plus FICA taxes on each dollar you pay your child (assuming you pay through W-2 as compared to 1099).

But be careful.

While income shifting is an excellent tax planning strategy, it’s not for the unorganized. You must run payroll and file the correct forms on an ongoing basis. You must document the job and substantiate the pay. And your child must produce a timesheet.