Hiring your children is a great way to teach work ethics, skills, and good money management habits. It is also a great tax deduction for the parent, too, when handled properly.
The opportunity is great, but the rules are plenty. Understanding these tax rules allows you to achieve the maximum tax advantage.
The tax rules are different based upon age and the entity structure of your business.
If your child is under age 18, your sole proprietor business, including rental income properties and farmers, can pay your child outside payroll taxes (FICA taxes: Social Security and Medicare). No 1099 or W-2 is required and the parent’s business can deduct the expense.
An LLC will not destroy the simplicity or the tax advantages (no payroll tax) as long as the LLC is a disregarded entity for tax purposes. Generally, if the business income and expenses are recorded on the personal tax return the tax advantages of hiring your child apply.
An LLC electing to be treated as either a C-corporation or S-corporation are regarded entities. Payroll to a child of the owner of a regarded entity are treated as any other employee. A W-2 is required. Payroll taxes are required. Reason? The child is your child, not the entity’s.
Partnerships with only the parents as partners also get the same tax advantage as a sole proprietorship. If the partnership has a non-parent partner, wages to your child will require a W-2 where the payroll tax applies.
Work Duties of the Child
There must be a real employment situation for a business owner to deduct wages paid to a minor child of the owner. Your two-year old child doesn’t qualify as the company accountant, for example.
Farmers live in the sweet spot. Putting the kids to work feeding calves, cleaning barns, or milking cows often starts at an early age. Wages paid to minor children do not require payroll tax withholding as long as the business is not a corporation. This is a massive tax savings for family farms.
The road can be wide. Your two-year-old child can get a wage under certain circumstances. If you have a children’s clothing company, it is reasonable that you would need children to model the clothes. Your child can be that model.
The important point here is that the child must earn the wage. Cleaning offices can be a reasonable job for your children. Facts and circumstances always prevail. The best guideline: Would you hire someone to do the same job if your child were not available?
The wage also needs to be reasonable. Wages paid to your minor child need to be similar to what is paid to a non-related party.
Tax Deduction Details
Before I dig into tax strategies to supercharge hiring your children, we need to clarify the rules.
The issue here is the payroll tax and unemployment insurance.
The payroll tax is called FICA. This is the flat tax withheld from an employee’s paycheck. The employer pays the same amount. The payroll tax is 15.3% in total; half paid by the employee and half by the employer. The Social Security portion of this tax has an upper limit unlikely to play a role when hiring your children. In short, the employee and employer each pay an equal amount of payroll tax. When the payroll tax doesn’t apply to the child, it doesn’t apply to the business (the parents) either.
Unemployment insurance is determined at the state level. Many factors come into play. The employer pays 100% of unemployment insurance. There is also federal unemployment insurance (FUTA).
Sole proprietorships and partnerships where the parents are the only owners get the favorable tax treatment listed above. LLCs taxed the same also get the same treatment. Cleaning apartments and helping with maintenance on income properties also applies as long as the activity is not taxed as a C- or S-corporation, or a partnership with a non-parent owner.
Your child can earn up to the standard deduction ($13,850 in 2023) tax-free. Your business still gets the deduction.
Up to age 18, payroll taxes are also avoided. Once your child reaches 18 you are required to withhold the payroll tax and income tax withholding, if applicable.
You avoid FUTA until your child reaches her 21st birthday.
Until the year your child reaches her 18th birthday, no W-2 is required and should not be issued. Your business deducts the expense. Your child will file a tax return return, reporting the income from your business as other income on Schedule 1.
While filing a tax return might not be required, it is a good idea to do so anyway.
Your minor child still gets the standard deduction. I will assume your child earns the standard deduction amount or less for this example.
Your child pays no income tax using the assumption above. Since there is no payroll or income tax, your child can fund their Roth IRA without current tax consequences. And all the growth is tax-free.
Time is your greatest friend when investing. By your child starting at a young age funding her Roth IRA, she is likely to have an outsized Roth IRA at a young ago. Early retirement is an option for her.
Youth Labor Laws
Following labor laws is still required when hiring your children. Use the link in this paragraph for more details on labor laws.
You need to track the hours and tasks performed by your child. This is good business; it is also necessary to prove your deduction. Just throwing a number out at tax time is a good way to get a deduction disallowed.
S-Corps, C-Corps and Partnerships
The favorable treatment of wages to your child require that the wage come from your business. You are the one paying your child for a business purpose. Household chores do not count.
An S- and C-corp are legal (regarded) entities. Your child is not the entity’s child. Therefore, wages paid from an entity to your child is wages treated as wages to any other individual. FICA, UI, and FUTA will apply.
Partnerships composed of the parents only also avoid FICA and FUTA on wages to minor children.
Partnerships with partners not a parent of the minor child must treat wages paid in the same manner as wages to any other individual.
Note: An entity, S-corp as an example, will still deduct wages paid to an owner’s child. The child still gets the standard deduction before income taxes begin. The child can still invest in a Roth IRA. The difference is the payroll tax and unemployment insurance apply.
Earned incomes (wages) are not the only income your child might have. Unearned income (interest, dividends, and capital gains) plays a role.
In 2023, $1,250 of unearned income is tax-free to a child up to the year they reach 18, and full-time students to age 23 where their earned income is not over half their support.
Unearned income can limit the benefits outlined in this article when paying your minor child for business related activities.
The S-corporation is a powerful tool for reducing taxes in many instances. If your S-corp pays your minor child for services a W-2 is required, along with the appropriate FICA taxes and withholding.
But there is a workaround.
If your business is organized as an S- or C-corporation FICA and FUTA apply to wages paid to your minor children.
But you can pay your minor children from a family management company to regain all the benefits of paying your children from a sole proprietorship.
A family management company is a sole proprietorship you set up to manage certain aspects of your S- (or C) corporation. The S-corporation pays a management fee to the family management company which pays your children. All the rules for paying minor children from a sole proprietorship then apply.
Paying your minor children is a simple concept. There are a few rules that need to be followed to gain the maximum tax benefit. These rules allow you a full tax deduction while your children benefit from tax-free income and the ability to fund a Roth IRA.
And the money lessons and work ethics acquired will serve your children their entire life.