You may have heard or seen somewhere that hiring your children to work in your business can be a great way to save taxes. But you probably also wondered if it is legitimate and how to actually do it the right way (because there are many boxes that must be checked). One of my financial planning clients recently asked me these questions. I wrote this in response and figured it would be good to share here so others can benefit as well.
In this article, you will learn about the tax benefits of hiring your children to work in your business and how you can do it in a legitimate way.
The Tax Benefits
Tax Benefits for the Parents
Hiring your children to do legitimate work is a deductible business expense. This directly reduces your business income and saves you taxes at your marginal tax bracket. For example, a business owner at the 32% federal tax bracket who also pays 9% in state income taxes would save 39 cents in taxes for each dollar of compensation expense paid (though partially offset by the reduction in the qualified business income deduction).
If your business income flows through Schedule C on the federal tax return, you would also save on self-employment taxes. This translates into saving 2.9% for Medicare taxes (and potentially 0.9% savings on additional Medicare tax on high income households) and 12.4% for social security taxes.
Paying wage expenses clearly benefits the parents/business owners, but doesn’t this just shift some tax liability to the children? As long as you stay below certain thresholds, it doesn’t.
Tax Benefits for the Children
Your dependent children won’t owe federal income taxes as long as their earned income is below $13,580 for 2023 and below $14,600 for 2024. These are the standard deduction limits for single filing status that also apply to minors.
In addition, children under age 18 are also exempt from FICA (social security and Medicare taxes) and FUTA (unemployment taxes) if the business is a sole proprietorship or a partnership in which each partner is a parent of the child. However, payments coming from a corporation or non-parent partnerships are subject to FICA and FUTA taxes. Thus, for the right business types, children can earn income completely tax free as long as they stay under the limits above.
If you really want to turbocharge the tax benefits, you can help your children contribute to their Roth IRAs. With no age limit, the main limitation to contributing to Roth IRAs is having sufficient earned income. Since children have such long investment horizons, money in a Roth IRA can really work wonders. For example, a 10-year-old who contributes the maximum $7,000 (2024 limit) to his or her Roth and compounds it at 8% will have nearly $0.5 million after 55 years at age 65. And that is just with one year of contributions! Imagine how much they would have if they maxed out the Roth every year.
Qualifying for the Tax Deduction
If you are drooling at the tax benefits and are ready to run home and hire your children, hold your horses. Because this is clearly an area that could be subject to abuse, you need to make sure to check all the boxes so that you qualify for a legitimate tax deduction. In other words, read the fine print.
Ensure the children are doing legitimate work for reasonable pay
At the end of the day, your children must be doing legitimate work in the business (i.e. having them stuff envelopes of marketing materials will count, but doing the household dishes won’t). Further, the work must be suitable for the capabilities of the child. Saying your 10-year-old is doing your bookkeeping is going to raise a few eyebrows. Hiring children under seven will be difficult to justify except for limited situations such as modeling for images/photos.
The compensation must also be reasonable and not excessive for the nature of the work. Don’t pay $30 an hour if the going rate is $10 per hour.
Document the work being performed
Saying the child performed the work is one thing, being able to document it is another. It is a good idea to write up a description of the responsibilities of your child’s job. You should also keep time sheets of when the work was done. Taking some photos or videos of the child performing the work would earn you extra points.
Fulfill your duties as the employer
If you are going to claim a business expense for compensation to your child, you had better actually pay your child. This means opening up separate checking accounts for your child and depositing checks into their account to create a paper trail.
As the employer, you should also have the child fill out the W-4 tax withholding form and the I-9 employment eligibility verification form. The child will need a social security number and you as the employer will need an EIN (employer identification number). You must also withhold income taxes and issue W-2 forms.
Check your state rules
Even if your child’s income is exempt from federal income taxes, they could still be subject to state taxes. California for example has a standard deduction of $5,363 for single filing status, much lower than the federal level. This means your child will owe some California income taxes once they exceed $5k in income while they can go up to $14k income before owing federal income taxes. Certain states could also have child labor laws or worker’s comp requirements that apply in certain situations.
Your child will likely need to file taxes
You may need to help your child file taxes. Even if they don’t owe taxes, if they had their income withheld, they will need to file a tax return to claim the refund.
Bonus Content: Does hiring your kids affect your solo 401(k)?
If you are a sole proprietor with a solo 401(k) you might be wondering if hiring your child as an employee would affect your eligibility for a solo 401(k), which as its name suggests does not permit employees. Fortunately, you are in luck. Hiring the business owner’s child does not affect the solo 401(k) as long as:
- The child is under 21 years of age regardless of the numbers of hours worked; or
- The child does not work more than 1,000 hours per year and does not work more than 500 hours per year for 2 consecutive years; or
- The child is a 3% or more owner of the company.
Meeting any one of the above three points would be sufficient.
Disclosure
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it.
The information in the article is provided for informational purposes only. It should not be construed as investment advice or advice on buying, selling, or other types of transactions relating to an investment in products or services, much less an invitation, an offer or a solicitation to invest.
The information in the article is provided solely by virtue of the fact that everyone will independently make their own investment decisions: the report does not take into account investment objectives, nor specific needs or financial situation. In addition, nothing in the article represents or is intended to express investment, financial, legal, accounting or tax advice. You should consult your own investment or financial advisor before taking any actions.
