Imagine this: You bring your child into the family business, not just to teach them the ropes, but also to tap into a little tax magic. It’s like giving them a fishing rod rather than a fish. You pay them for their work—fair and square—which is good for them, and you get to write off their salary as a business expense, which is good for you.
Now, your child’s piggy bank grows tax-free up to a point, thanks to the standard deduction. And your business?
Well, it’s like planting a tree that provides shade and also drops a few apples into your tax basket. Of course, the tax code is a tricky river to navigate, and you’ll need a seasoned guide. A financial advisor can be your compass to ensure this strategy benefits your family’s financial landscape. It’s a win-win, with the right rules in play.
Non-Tax Reasons to Put the Kiddo(s) to Work
In the heartland of America, the family farm isn’t just a homestead; it’s a seedbed for values like hard work, financial savvy, and the entrepreneurial spirit.
Nowadays, though, it seems fewer kids are learning these lessons in the fields and barns of their youth. But here’s an idea: why not bring them into the family enterprise? It’s a chance to pass on more than just how to balance a checkbook—it’s about nurturing seeds of future financial independence and maybe even business ownership.
Finding reliable help is tough in today’s market, and many entrepreneurs overlook the eager workforce dining at their own table. Why not employ this homegrown talent? They can learn the ropes while you enjoy the flexibility of scheduling family labor.
And let’s talk about a golden opportunity: funding your children’s nest eggs. If your children have earned income, they can open and fund a Roth IRA. Whether they’re just learning to count and you’re opening a Roth IRA that could blossom into a fortune, or they’re in their thirties and it’s high time to start a 401(k), remember—it’s never too early, nor too late, to plant the seeds of retirement savings. It’s a prudent move that can yield a bountiful harvest in the years to come.
Paying Kids Under 18
The advantages of employing one’s offspring, particularly those under the tender age of 18, are twofold and too significant to ignore.
To begin with, when you compensate your youngsters, Uncle Sam kindly turns a blind eye to income and payroll taxes—yes, I’m referring to the notorious FICA. It’s like finding a rare coin in your pocket change; it’s a small delight that adds up. The Internal Revenue Code, specifically Section 3121(b)(3)(A), along with its accompanying regulations and publications, outlines this exemption. However, do take note that the State of Washington marches to the beat of its own drum, so a quick perusal of their Department of Labor’s rules is prudent.
Moreover, the government and insurance entities operate on the assumption that familial bonds are stronger than legal ones; they presume that your children won’t drag you to court over a workplace mishap. After all, they’re likely covered under your health plan, and you’d foot the bill regardless.
Moving on to the second point, it’s as if there’s a ‘no taxation’ sign hung on the first $12,550 of everyone’s earnings in the U.S., including our children. This is courtesy of the Tax Cuts and Jobs Act, which has sweetened the standard deduction pot. And let’s not forget about the “Kiddie Tax,” which, contrary to its name, doesn’t nibble away at earned income.
You can still proudly claim your offspring as dependents and bask in the glow of the child tax credit. The cherry on top? Your children’s earned income up to $12,550 remains in their piggy banks, untouched by taxes. Steering clear of the “Kiddie Tax” is as straightforward as avoiding a bad investment.
Remember, the best investment you can make is in the education of your children, and what better way to start than by teaching them the value of a dollar earned and wisely saved.
They Have to Actual Work and Earn It
When it comes to integrating your progeny into the family business, the approach is straightforward. If your offspring are earning their keep, it’s only fitting they receive a fair compensation for their contributions—be it in an operational enterprise or a rental property venture. This isn’t merely a paternal gesture; it’s a savvy move that translates into a tax-deductible expense, effectively shifting income within the family while adhering to the tax code.
Let me be clear, this isn’t about orchestrating a charade. The involvement of your children must be genuine, with meticulous records of their labor and compensation that reflects the market rate.
Casual household tasks won’t cut it. This is about legitimate business, not a loophole to exploit. Remember, the IRS has a keen eye for these matters, and a misstep here could invite scrutiny you’d rather avoid. It’s prudent to heed the lessons from U.S. v. Renfrow—play it straight, and the benefits will follow.
Example
An illustration can help demonstrate how this concept can be put into practice. For instance, if you operate a small social media consulting business as a sole proprietorship, and you decide to employ your 16-year-old daughter to manage your company's Instagram account at a rate of $12 per hour.
Over the course of 12 weeks in the summer, she works 10 hours per week, earning a total of $1,200. You pay her wages and can deduct the $1,200 on your business tax return.
During tax season, your daughter files her own tax return. If she is not claimed as a dependent, she can take the standard deduction for single filers. However, if she is considered a dependent for tax purposes, she can claim a standard deduction of $1,250 or her earned income plus $400, up to the full standard deduction for single filers.
This ensures that her $1,200 wages remain untaxed at the federal level. By appropriately hiring your minor child, you can save 7.65% in payroll taxes (Social Security and Medicare), amounting to $91.80 on the $1,200.
Additionally, your child saves 10% on her $1,200 income, equating to $120 in federal income taxes. As her earnings from working for your business increase, her tax savings also grow, up to the standard deduction threshold.
Now for the technical side....
Follow Protocol
Here is the process: The IRS permits any sole proprietorship or partnership (LLC) fully owned by a child's parents to pay wages to children under 18 without withholding payroll taxes, categorizing it as "outside labor" as an additional expense, not as payroll. A W-2 form is not required as there are no withholdings, and the penalty for not filing a W-2 is based on withholdings, which are nonexistent in this case. Therefore, issuing a W-2 is merely a formality.
The IRS is unconcerned about the absence of a W-2 since no FICA, FUTA, or SUTA is due or withheld. We only suggest issuing a W-2 if your child intends to contribute to a Roth IRA (an excellent strategy, by the way!). In such situations, we want the IRS system to correlate the child's IRA contribution with their earned income. While there is no penalty for not doing so, it's advisable to maintain a positive relationship with the IRS system.
CAUTION - If you have an S or a C-Corporation, you will not benefit from avoiding FICA taxes when paying your children under the age of 18...UNLESS you channel the funds through a sole proprietorship 'management company'. It is not advisable to directly compensate your children from the corporation as you will then be required to withhold payroll taxes (IRS Pub No. 15, (2011), p.10). Therefore, our suggestion is to remunerate children through a family-owned management company (sole proprietorship). This can be achieved by issuing a valid management fee from the S-Corporation to the sole proprietorship, and subsequently compensating the children as "outside labor" (classified as an 'other expense') from the Sole Proprietorship or Single Member LLC.
Restrictions on Hiring Children
Although hiring your child can be financially beneficial, it may not be a suitable option for all taxpayers. If you are contemplating this, consider the following restrictions:
To be eligible for the deduction, you need to have self-employment or business income; it is not applicable for salaried employees.
Your child must be under 18 years old for their wages to be exempt from Social Security and Medicare taxes.
Once your child turns 21, you will be required to pay federal unemployment taxes on their wages.
If the pay rates for children are deemed unreasonably high by the IRS, they may raise a flag if it exceeds the standard for their responsibilities.
Both you and your child must adhere to all documentation and reporting obligations. Failure to do so could void the tax advantages and potentially result in IRS penalties.
The IRS is unlikely to be lenient if you breach these regulations. However, the requirements are not overly burdensome, and significant tax savings can be achieved if everything is handled correctly.
Disclosures
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