Business owners hire their children for sound reasons such as instilling a strong work ethic, teaching responsibility, encouraging entrepreneurship, reducing taxes, and saving for a college education. The Tax Cuts and Jobs Act of 2018(TCJA) enables the last two of these benefits. A parent who owns a business and has children under the age of 18 can use the TCJA to lower taxes and help their children accumulate savings for a college education.
Tax Benefits of Hiring Children
Business owners are allowed to hire and pay wages to their children. In doing so, they transfer some of their income, which is taxed at a high rate, to their child, who is taxed at a low rate, thereby reducing the amount of taxes that they pay.
Benefits to business-owner families include:
- A child can be employed by the family’s business to do legitimate work. For example, assume that a child is paid an annual wage equal to the standard deduction of $13,850. There will be no taxes due on this income. If a parent pays more than $13,850 to their child, the excess will be taxable but at the child’s low tax bracket, which is usually only 10%.
- A business treats wages as an expense and so receives a deduction for all wages paid to a child. This decreases Federal and state taxable income for the parent’s business by the amount of the child’s wages.
- Parents don’t need to pay Social Security and Medicare (FICA) payroll taxes for children employed in the business if it is a sole-proprietorship, single-member LLC, or an LLC taxed as a partnership owned solely by the parent. There’s no FICA exemption for employing a child in an incorporated business (S or C Corporation) or in a partnership that includes non-parent partners. In these situations, the child is subject to the same payroll tax rules as all other employees. However, there’s a way around this restriction by paying the child’s wages out of a Family Management Company (FMC) instead of directly from the business. The FMC would enter into a management contract with the business and would pay the children directly.
Helping College Savings
A child may opt to use the wages earned from his or her job in the family business to save for college. Accumulation of funds for college can be accelerated by choosing a college savings plan instead of a traditional bank account or savings instrument. In recent posts, we have described the pros and cons of several tax-advantaged instruments that have been authorized by Congress for this purpose.
Instead of a college savings plan, the child may opt to set up and contribute to a Roth IRA. The only requirement for a child to be able to make an annual IRA contribution is to have earned income that at least equals the amount contributed. Age is irrelevant. If a student earns wages from a summer job, a part-time job after school, or a job in the parent’s business, he or she is eligible to make IRA contributions. What’s more important in this context is that withdrawing money from the IRA will not incur a penalty for premature withdrawal if the funds are used to pay qualified college costs.
Types of Jobs
For those families who own and manage a farm, hiring children is quite common. The range of jobs that are suitable for children on a farm is extensive, and chances are that the children would be performing some of them anyway.
There are also many jobs that children can perform in a non-farm business. They should be paid the same wage that would be paid to any employee to do the same work. Examples include:
- Cleaning the workplace after hours
- Washing company vehicles
- Updating customer lists and databases
- General data entry and verification
- Transcribing video and audio recordings
- General off-site errands
- Helping at meetings by passing out documents and setting up equipment
- Distribution of advertising fliers and coupons
- Updating the website and social media accounts
To employ children in compliance with IRS regulations, a parent needs to ensure that they are performing legitimate work and have accurate position descriptions for their jobs. Their hours should be tracked and the tasks that they perform recorded. The work should be age-appropriate and they should be paid a fair wage for it. The minimum age at which children can be legally employed is 14 according to the Fair Labor Standards Act, but there are exceptions allowed for younger children depending upon the nature of the work.
The best source for compliance information is IRS Publication 929 – Tax Rules for Children and Dependents. The latest edition is for Tax Year 2022. A parent who is considering hiring a child to work in the family business and wants to stay apprised of regulatory changes can refer the IRS website at IRS.gov/Pub929.
Examples of the Effects of Hiring a Child:
Consider a parent in the 37% tax bracket who owns an unincorporated business. He hires his child and pays the child $16,000 for the year. He reduces his income by $16,000, which saves him $5,920 in Federal income tax (37% of $16,000). His child has a taxable income of $3,450 ($16,000 less the $13,850 standard deduction), on which the taxes owed are $345 (child’s tax bracket of 10% times $3,450).
If the child is under age 18, he or she is not subject to FICA payroll taxes on the $16,000. A child under 18 employed by an unincorporated family business is exempt from FICA. Under normal circumstances, the FICA payroll tax would be 15%, or $2,400. Half of that would be payable by the child as a regular employee and half by the business. Thus, the child will save $1,200 and the parent-business owner will save $1,200.
To size the potential benefits to IRA accounts, let’s assume that a 13-year-old had contributed $1,000 from wages to a Roth IRA at the end of each of the five years prior to attending college in 2023 at age 18. If the annual rate of return on these funds is 5%, this $5,000 contribution would be worth about $7,000 in 2023 at the start of college. If the account is not used for college and the contribution rate remains the same, the child will have about $200,000 in his or her IRA upon turning 60 in 2067.
As another example of IRA benefits, assume that a child was paid $13,850 as an annual salary. The parent-business owner could pay up to an additional $6,692 (50% of salary) into a deductible Roth IRA on behalf of the child. The child’s taxes owed would remain at zero as described above, but the business would deduct $20,077 for the child’s wages of $13,850 plus the 50% IRA contribution of $6,692, reducing taxable income proportionately, and the child would have that much more value in their IRA account.