The federal income tax was first enacted in 1913. The tax code was relatively concise, and in these simpler times family businesses were once the backbone of the US economy. The tax code is now several million words long and requires a vast majority of people to use a tax professional in order to navigate it. But despite its complexity, there are various parts of the tax code that cling to the ideals from the its early days: family businesses are one of them.
It’s less common for business owners to pass their companies directly onto their children and keep it running in perpetuity since we live in a more mobile world today where adult children are more encouraged to pursue their own dreams. But whether the business will be passed onto your children, sold at retirement, or passed onto an unrelated successor, favorable treatment has remained in the tax code for hiring your own children to work at your company. It used to be a given that "keeping it in the family" was just what you did in the early 20th century before things like valuing children’s education and child labor laws also came about. But the tax code still allows you to reap some massive benefits for hiring your children.
How Your Family Benefits From Hiring Your Own Children
Just like you would with an unrelated employee, you can deduct the wages or salaries paid to your own children as a normal business expense. However, a major difference between hiring your child opposed to an unrelated person is that if your child is under 18 then you don’t have to pay FICA and FUTA (Social Security, Medicare, and federal unemployment insurance) payroll taxes in a majority of cases. This benefit only applies if your business is a partnership or sole proprietorship, however, there workarounds if you operate as an S or C corporation such as a family management company.
Unless your profit level is extremely low, this effectively shifts your business income to your child’s tax bracket which is likely to be practically nonexistent. This represents significant tax savings both in terms of income tax and payroll taxes and related administrative burden. Your children also receive what is essentially tax-free income providing that their wages fall below the standard deduction amount for the year.
As an added bonus, your children learn the value of having their own money and can start paying their own way for things they want as well as starting to save for college and other major expenditures such as retirement savings. Your child can reap enormous tax savings in the future by putting their paychecks into a Roth IRA and letting the funds grow tax-free while they’re very young.
Your Children Must Still Be Bona Fide Employees
This means that you need to comply with all of the same regulations that you would with hiring an unrelated employee, such as having your child fill out an I-9 that certifies their eligibility to work in the US. Your child needs to fill out a W-4 (and state equivalent) for tax withholding and a W-2 must be issued to your child just as they would receive from any other job. Even though they would be exempt from Social Security and Medicare taxes in most circumstances, your child may still need to file a tax return in order to get any withheld income taxes back.
After paperwork formalities are taken care of, the job must be a legitimate need for labor that your business has. Since this dated, but still effectively employed, method results in major tax savings the IRS is often watchful as to what constitutes a "real employee" of the business when that employee happens to be your child. The wages paid must be ordinary and necessary for your business for services actually performed, opposed to nondeductible personal services your child is performing such as childcare or maintaining the home. Even if your child is helping with menial tasks like stuffing envelopes, answering phones, keeping business social media pages up to date, and keeping the office clean, all of those services count for this tax benefit.
You also must comply with child labor laws. The IRS hasn’t issued definitive guidance on what age is considered too young to perform helpful or necessary services for your business, but it’s safe to assume that most children under 10 wouldn’t pass muster. Regardless of age, your child must be under 18 to avoid payroll taxes.
The amount paid to your child must be below the standard deduction amount for the year in order for them to pay no tax. However, there’s no limit for the parent to shift business profits to their child in the form of wages, wages with no payroll taxes if that child is under 18. Even if your payments go past the standard deduction amount, your child is far more likely to be in a lower tax bracket than you.
Since this statute could be easily abused, the IRS enforces a reasonable compensation rule on paying your own children to help with your business. A basic rule of thumb is think about what you would pay a total stranger for the same kind of work. Your child’s total compensation should be in line with that going rate you’d pay a stranger, along with any fringe benefits that your spouse receives if they participate in your business such as health insurance premiums and medical expense reimbursements. Paying your child $75 per hour to stuff envelopes would not hold up in Tax Court. But if you need help with administrative work for example, research how much an entry-level administrative assistant earns in your area by the hour. You can start with statistics from the Department of Labor and workplace sites like Glassdoor, as well as contacting local employment agencies and asking what the going rate is for the type of work you want your child to do.
While you still have the same administrative burden of having your child work for you as you would a total stranger, there are more tax benefits and overall financial benefits to your entire family to have your child work for you instead. In addition, you’ll be bringing your family closer together and instilling work ethic in your child. They will also have the opportunity to utilize the same savings tools as you such as Roth IRAs and 529 plans to let their wages grow tax-free to pay for college and retirement in the future, as well as having their own money for personal purchases to learn the value of a dollar.