Business Tax, Tax Planning

• You may be able to save considerable amount of cash in the form of tax savings by hiring your kids

• Your children may learn valuable business skills that they will keep for their lifetime

• The federal government, via tax preferential treatment encourages hiring children for your business

• The work and amount of pay must be reasonable in relation to each other, and in relation to the age and knowledge of the child.

• If improperly setup or executed, the business owner may face fines or lose some or all of the savings desired

• Your state may also have rules you must follow and may differ in tax treatment and other requirements

**Quick disclaimer, while I am an attorney, I’m not your attorney or tax advisor without an express written agreement stating otherwise. You should NOT consider this legal or tax advice, and only as it is, namely educational material that should be used as a starting point, not a determination of what is right or wrong for you and your business.**

Owning and operating a small business can be an immensely rewarding endeavor financially and mentally, albeit it also comes with its fair share of challenges, especially when it comes to tax liability. One often overlooked strategy for business owners that can provide significant tax savings is hiring your own children to work in the family business. Considering taxes can easily eat up a large share of your profits, understanding how to minimize your taxes is vitally important.

While this approach requires careful adherence to various rules and regulations, the potential benefits make it well worth considering. Some taxpayers save thousands of dollars each year by changing how they structure their business operations.

If your situation allows for hiring your kid to help with your business, you may find the financial and educational benefits outweighs the rules, burdens, and requirements that must be followed in order to do so.

Let’s start with the main advantage, and the one that gathers the most attention, is that currently, for tax year 2024, a single taxpayer is generally allowed a standard deduction of $14,600. This means, as an employee (not subcontractor which I will discuss in further detail below), your child (actually most anyone) can generally get paid up to the standard deduction and not pay any income tax.

Furthermore, the child or other employee earning less than the standard deduction generally doesn’t even need to file an income tax return (although sometimes is advantageous for them to do so, which I will also explain below). The essence of how this works is simple in concept and looks like this…., the parent is able to deduct from their income the amount paid to the child, thereby reducing their taxable income, which is often (almost always actually) much higher than the child, and then pay the child who is not paying any (or a much lower tax rate if the income exceeds the standard deduction) federal and state income taxes on the income the child earns working for a parent(s).

As a quick example, for a parent that would otherwise personally take the income and pay income taxes at a marginal rate, this may result in a savings of potentially 37% from federal income tax (although, for most parents, the federal tax savings is lower, albeit savings of at least 22% is very common). For businesses that are located in states with an income tax, which is most of the states as well as most of the American population, the savings is also increased by the amount of marginal tax reduced as well.

For example, a parent paying a child $10,000 this year may save $2200 or more if the income is also subject to state income tax.

The next key point and savings that can be realized, is that for child employees under the age of 18, neither the parent nor the child is required to pay payroll taxes comprising of Social Security (FICA) and federal unemployment (FUTA) taxes, as long as the employment is structured properly. It’s very important to structure the strategy correctly to avoid missing out on this savings. How important is this savings, well, assuming a child under the age of 18 is paid $10,000 in 2024, the FICA and FUTA savings is likely about $1500.

The actual savings may vary depending on several factors, including how much of the income would be subject to FICA and FUTA if the parent simply took the income, however, for a sole-proprietorship, including a disregarded LLC entity, it’s likely around $1500. Again, the savings is not exactly $1500, albeit it’s a good reference starting amount to use for determining if it’s worthwhile or not.

As you can quickly see, when a parent combines the income, Social Security, and Federal Unemployment tax savings of hiring a child, the percentage of income saved can be substantial, and it’s a strong motive for a business owner parent to determine if hiring a child is worth pursuing. And we’re only talking about how much money is saved in tax, which is in addition to the skills learned and business involvement for the child which is often overlooked and discounted in the beginning, albeit can turn into the biggest advantage over time.

Moreover, many parents, including myself, gain great joy in working with their kids. My one son who is past the eligibility of this tax strategy works with me daily and is one of the best things I cherish about being in business for myself.

Ok, you’re likely “sold” on the idea if you’re still reading, and now the next question that always comes up is “what’s the catch” and there are several.

You must remain in compliance with the rules, which include:

Legitimate work:

Your kids must perform bona fide, age-appropriate work that is necessary for the operation of your business. Cleaning their room, or performing household duties is obviously likely NOT necessary for the operation of your business. Having an eight year old perform advanced bookkeeping work is also not likely going to pass muster as well. Because there are so many different types of businesses that have various degrees of potential work that can be performed by staff under 18, it’s impossible to list all the tasks they may be able to perform for your business, I will highlight some common tasks that if their age, intelligence, and knowledge reasonably supports, may be considered.

These include – clerical work, social media management, and child modeling (ie pictures for your business website). For clerical work, maybe they deposit checks into your business using your phone app. Scanning and shredding documents, data entry, placing bills in envelopes and mailing, opening mail, cleaning, vacuuming, and taking out the garbage in the work office, backing up hard drives and computer data, taking pictures for the business, and all sorts of tasks that maybe you as a parent would rather not have to do yourself, and you would otherwise hire someone to do anyway.

Reasonable Compensation:

You must pay your children a reasonable amount of compensation for the actual work performed. Surprising to some, this also means not paying too little. You’re still required to pay the minimum wage based on federal, state, and local regulations. You can run afoul of employment law if you pay too little based on the amount of time worked.

Moreover, you can not overpay for the amount of time, skill, and work performed neither. In other words, you must pay a reasonable amount for the actual work performed, and generally a good place to determine the amount of pay is what would you pay another person of the same age and abilities who isn’t a relative for the actual work. If you pay too much, you can expect the state and/or the IRS to pushback and determine it was unreasonable, causing you to roll-back some or all of the compensation, and pay the taxes as if you didn’t pay your child.

Because these determinations almost always happen after the fact, the roll-back of income is likely to cause penalties and/or interest on the failure to report and pay. In other words, you can’t simply makeup an amount based on what you want without first determining what’s appropriate and expect to be “ok” from a tax liability point of view.

Documentation:

You want to generate and maintain proper appropriate documentation as you would with any employee regarding the duties, time schedule, and compensation with the expectation that it may be reviewed by the state and/or IRS. Having a full employment contract with set expectations and compensation that are reasonable in light of all relative factors. Because the IRS tends to scrutinize any, including child employee business relationships, involving related parties, it’s essential you have and keep proper documentation generated to substantiate all business dealings with your child employee(s).

Compliance with Labor Laws:

As touched upon above, just because the employee is your child, doesn’t mean you can ignore labor laws, including, and especially child labor laws. This includes the hours worked, how many hours, and any other requirements based on your state and local rules. While a 40 hour work week may be appropriate for a 17 year old during summer break, it’s not likely permitted for a 12 year old during the school year.

Some states, including Wisconsin make no exceptions for workers’ compensation requirements, while others allow related employees to work without workers’ comp insurance. That being said, even if your state doesn’t require it, it still may be a good idea in case the work they’re performing could cause an injury. At a minimum, it should be considered even when the parent employee is not required to have it in place. For states that require workers’ compensation, you should budget about $300 a year, albeit it can vary widely depending on if they’re doing office related type of work, or outside/warehouse type of work.

If you’re still of the opinion this may be a good option to consider, here are some reasons why it may not make sense.

Increased Audit Risk:

As stated already, you can anticipate a greater likelihood of an audit. To be clear, generally, the risk of audit shouldn’t be a factor because if any given position by a company is well substantiated through proper documentation and is allowed under the laws and regulations, an audit is not a “big deal” most of the time. Most audits are performed via mail and requests for documentation isn’t necessarily a serious burden. However, from a pragmatic point of view, even when legitimate and there is no risk of penalties, fines, or additional costs, if there is very little tax savings combined with additional cost and work if audited, sometimes it makes sense to just pass on any given strategy. That’s a question only the business owner can make as people have different views and opinions on what is worthwhile and what isn’t. In order to help determine if any given strategy makes sense for you, it’s important to receive competent and professional tax advice from someone who can properly guide you.

Complex Rules to follow:

Because hiring children is the exception rather than the rule for hiring staff, the rules involved may seem complex and daunting, especially for a new business owner still trying to figure out the rest of the business operation. Again, this is a situation where having proper guidance is key.

Financial Aid Impact:

Often colleges and financial aid is based on the amount of income earned and if your child employee is earning income, this may impact in ways that are not initially thought about, including potentially financial aid for college.

Things to generally avoid:

Hiring your child as a 1099 subcontractor. While doing so can make sense in some limited circumstances, the strategy of hiring your kids as 1099s is something I hear advised often from people who are not tax professionals because they don’t understand that as a 1099, the child employee may still be subject to self-employment tax. This is because the threshold limit for reporting self-employment income is much lower than as an employee. And a child employee may lose one of the biggest benefits, namely not having to pay FICA tax.

Putting the income earned into a Roth IRA. I should first explain why some do this. The theory is that the child employee can place money into a Roth IRA, have it grow tax free, and at some point in the future (ideally at retirement) take the earnings out tax free. This sounds great at the surface level in theory, however, for most, it fails to take account that the child can often if not likely, obtain a better result by simply placing the money into what is otherwise an investment/bank that is subject to income tax because for many, they’re not earning enough to go beyond the standard deduction allowed.

This one admittedly “depends” on the situation, however, if the child isn’t earning enough to pay taxes on total income, including interest earned from savings, it generally doesn’t make sense to setup a payroll and the other costs associated with being able to make contributions to a Roth IRA. Again, I must stress it’s a nuanced and fact specific situation, however, I see many creating Roth IRA accounts for kids that really see little if any actual benefit from doing so.

This is especially true for younger child employees that could otherwise earn tax free interest in a non-retirement account until they earn enough that it “matters” and then at that point they could take their savings and place it into a Roth IRA. For parent employers without any other employees, and therefore have to run a full payroll, along with the costs of a payroll, the costs greatly outweigh the benefits, if any at all, compared to having the funds placed into an investment vehicle, including CDs and other bank-related choices.

Creating or subscribing to a payroll service and/or software.

Along the same lines as a Roth IRA, many, if not most, states don’t require any formal payroll. If you don’t have to run a payroll and the associated costs, the better option is to not do so. There are more than one way to deduct your expenses from your business that often doesn’t include an actual payroll processing to pay your children. This is again highly nuanced and requires a professional to evaluate your specific situation to advise how to properly setup the deductions as an expense if you’re not running a payroll.

Having your child work directly for your separate entity. One of the primary rules is that the child must be an employee of a parent(s). If you hire your child directly from your separate entity, you may or may not be able to take advantage of the tax savings desired. This requires careful and exact consideration to know if the strategy will work or not. From the IRS point of view, a business that is a sole proprietorship or partnership (where each partner is a parent of the child) is permitted (all else being equal and allowed) to take advantage of this strategy.

On the other hand, a Partnership,  LLC or Corporation that is not wholly owned by the parents may NOT take advantage of this and are subject to FICA, and other payroll taxes, even if majority owned by the parents. This can be an issue if the parents also have other relatives with partial ownership, including if one or more of the children have an ownership interest. For many businesses, especially the ones that have an interest in tax savings, an S-corp election is a problem too, even if wholly owned by the parents.

One workaround is hiring your kids in a sole proprietorship, often called a “management company” by the parents. The S Corp entity subcontracts work to the management company that is a sole proprietorship,which in turn hires the under 18 year old child. This two-step approach requires the parents to create a sole-proprietorship, which is an additional form on their personal taxes. The net result is zero income/expense ideally, although if workers’ comp or other expenses are incurred, it does create a requirement to carefully plan so that no income is realized, or the income will likely be subject to self-employment tax.

Furthermore, additional suggestions are encouraged, including opening a separate checking account (not required, albeit is beneficial in the case of an audit as it limits what is audited), obtaining a free EIN number for the sole proprietorship (again, not required, albeit it’s a means to protect your social security number), and depending on the jurisdiction, a payroll service if required. Doing so may possibly increase the cost of your tax preparation, although it should likely be minimal as there’s not likely a lot of activity.

The next step in determining if it’s a good idea or not is to first determine the maximum savings you may possibly realize. Determine what, if any, tasks your children can perform, how much they’ll earn if you hire them, the quality of the work (I don’t need to tell parents that motivating their kids to do quality “business grade” work isn’t always easy), and the interest of the kids they are considering hiring.

Once you determine how much you can reasonably pay them in a year, you will have an idea of if moving forward makes sense or not. As a starting point, and it varies greatly from jurisdiction to jurisdiction, I would suggest that if you can reasonably pay at least $3000 a year, and thereby save at least $1000 in taxes, it likely is worth exploring. On the other hand, if you’re thinking of paying them $1000 a year, maybe it’s not worth the time, effort, and additional costs.

Logistics:.

You must actually pay your child employee. This may sound painfully obvious, albeit some parents have the idea that they “will keep and manage the money,” which is a great way to run into trouble with the IRS. As an employer, even for your kid(s), you must pay them based on the employment agreement, and actually make deposits into an account in your child’s name. Technically, you could maybe pay in cash, however, cash doesn’t leave much of a papertrail, not to the extent of actual checks or direct deposits, and you WANT a papertrail

Some parents will then use the money in the account to pay for things the parents may have paid for before. For example, the family goes out to eat. Instead of obtaining one bill for the meal, get two bills and have the child employee pay for their own meal using their debit card. Your child needs new shoes, again, instead of the parents using their after-tax income to pay for the shoes, have the shoes paid for by the child’s debit card. Taking your kid to a basketball tournament, have your child pay for the gas, hotel, and entry fees themself instead of you using after tax dollars from your account. You likely get the picture here, namely that you still do the things you’re already doing and paying for, and the only change is HOW you’re paying for them. Instead of paying the “dumb” way, you become tax smart and save a lot of money in the process, all while knowing if you do things correctly, you are in full compliance with federal tax law.

Final thoughts and comments. Yes, that’s my son Michael “mowing” the lawn in my backyard. No, he’s not being paid from my company for mowing the lawn, although if I did pay him, some of the expense based on the amount of office space in my home MAY be reimbursable by my company as part of the expense. If I have clients coming to my home, it’s more justified, otherwise, if it’s not a true office expense, the work isn’t deductible. However, there’s no reason why he absolutely couldn’t get paid as talent for the picture if the intent was to use him as talent to create an image for the article. If he was paid, it would still have to be reasonable, and given the amount of images out there that could be used, it’s likely the amount of compensation would be less than many would like to pay. Certainly, at least in this situation, $500 is excessive, and likely even $100 would be excessive.

My point here is that unless your child is a true professional, paying $500 plus for a photoshoot may seem desirable from a taxation point of view, you can’t use the tax benefit to justify the amount of compensation. In my case here, it took less than a dozen or so shots to get the best I was going to get, and that took all of less than probably 15-20 minutes (I wasn’t keeping track because I didn’t have a need to).

As with all business decisions, it’s important that you can go into an audit situation where you’re not losing a night’s sleep because you tried to get cute with your numbers. This includes not allowing the relatively low audit risk to play any role at all in your choices. Too often it becomes a slippery slope and once the can is open, what could have been an easy stress-free audit turns into multi-year audits, with an ever-growing amount of things that get examined and scrutinized, and you get the picture hopefully that it’s simply not worth it. This is especially true given there are so many ways to reduce your taxes that are allowed if you follow the rules that generally will keep your rates lower than others without the stress and potential risk to reputation. 

If you would like to explore hiring your children as a tax saving strategy further, feel free to reach out, or discuss the matter with a tax professional.