Paying your children for working in the business has to be one of the most underutilized tax strategies by small business owners with families today. If your children, young or old, work for you in your business (or should be), it’s important to pay them for their services in the business.
Many don’t realize that paying your children properly is an excellent strategy to minimize their tax liability, not to mention it creates a host of other ancillary benefits. However, if it’s not processed properly on the ‘books’ and ‘tax return’, it can be an audit risk and frankly more of a pain than raising the kids (well not really).
The Non-Tax Reasons
- The days of the farm are continuing to disappear all across America and more and more children are leaving the home without work ethic, money management skills, and a concept of entrepreneurship. By getting them involved in the business you might be able to better teach them about future financial success or even business ownership.
- Getting help in the business and finding good workers can be difficult today. Many small business owners forget that some of their most affordable labor is right there in the house with them eating at the dinner table. Get them involved in the business and control their schedule a little more flexibly than other ‘outside’ employees!!
- Another major benefit is the ability to fund your children’s retirement accounts at any age. Whether they are under age 10 and you want to start the Roth IRA that will grow exponentially into millions down the road, or helping a 30 something that needs to start a 401k and learn it’s ‘better late than never’ to begin saving.
Paying Kids Under Age 18
The beauty of the tax benefit paying kids under age 18 is two-fold, and I can’t overemphasize the importance of understanding these features.
First, when you pay your children under 18, you don’t have to withhold any income taxes OR payroll taxes (that’s the ‘F’ word I’m talking about: FICA). (See IRC Code Sec. 3121(b)(3)(A), IRC Reg Section 31.3401(a)(4)-1(b), and IRS Pub No. 15, (2011), p.10) This also applies to Workers Compensation (unless you are in the State of Washington- make sure you look up the rules for even your own kids at the WA Dept of Labor here).
Yes, that’s right. There is no federal payroll tax withholding on your own kids, and this is the general rule and reasoning regarding Workers Comp in almost all the states. This is because the government and insurance carriers don’t assume your children will sue you if they are hurt on the job- at least we hope not. They are also probably on your health insurance plan and you’ll pay the bill one way or another.
Second, all of us in the U.S. and including our children, don’t pay taxes on the first $12,550 of income this year in 2021! (See TCJA and increase in the Standard Deduction. Rev Proc 2011-52, Sec. 3.11(1), 2011-45 IRB).
Also, the “Kiddie Tax” (if you have ever heard of that) doesn’t apply to ‘earned income’, AND you can still claim your children on your tax return as a dependent and even tax the child tax credit. But again, the child doesn’t pay taxes on their earned income on the first $12,550! I don’t want my clients paying the “Kiddie Tax” and it’s easy to avoid.
If you have Grandchildren that you are supporting, or want to support, AND they could be of help in ANY of your business operations, there is a different strategy involving an extra step, but just as effective. See my article: “Paying Your Grandchildren for the Business”.
Make Sure They Earn It
Now the strategy: Where do the kids get earned income? You take a tax deduction in your business for paying your kids a legitimate wage for legitimate work and services they provide to the business…ANY business (operational or rental). Thus, you generate an excellent tax-deductible expense for your income taxes (inside your business) by pushing income to your children.
Of course, I’m not advocating paying your children as a ‘sham’. They have to be legitimately involved in the business and you want to keep records of their time worked, as well as pay them a reasonable wage. Hiring your children to simply do ‘family chores’ is not going to qualify as a valid deduction and will certainly set you up for an audit. (See U.S. v. Renfrow, 104 AFTR 2d 2009-5497, 1/26/2009).
Following the Proper Steps
Here is the procedure: The IRS allows any sole proprietorship or partnership (LLC) that is wholly owned by a child’s parents to pay wages to children under age 18 without having to withhold the payroll taxes and list it as “outside labor” as another expense. NOT Payroll. You do not have to issue a W-2. This is because there is no withholdings and the penalty for not filing a W-2 is based on the ‘withholdings’. But see…there aren’t any withholdings…thus no penalty…and thus the W-2 is perfunctory.
The IRS doesn’t care if there is a W-2 because there is no FICA, FUTA or SUTA due or withheld. The only time we recommend a W-2, is if you plan to have your child contribute to a Roth IRA (a great strategy btw!). In those instances, we want the IRS computer to match up to the kid’s contribution to the IRA with their earned income. Again, no penalty if you don’t, but it’s nice to keep the IRS computer system happy.
CAUTION- If you have an S or a C-Corporation you do not receive this benefit of avoiding FICA when paying your children under age 18…UNLESS you push the money through a sole prop ‘management company’. Don’t pay your children out of a corporation, or you have to withhold payroll taxes. (IRS Pub No. 15, (2011), p.10). Thus, we recommend you pay children out of a family-owned management company (sole prop). You do this by paying a legitimate management fee to the sole-prop from the S-Corporation, and then simply paying the children as “outside labor” (an ‘other expense’) out of the Sole-Proprietorship or Single Member LLC.
Paying Your Kids 18 or Older
This is a very important and powerful strategy if you are continuing to ‘support’ an adult child, AND getting their help in the operation of your business. If this is the case, then essentially you have two options
- pay them as an employee with all the other ‘rank and file’ employees following W-2 procedures, or
- pay them as a sub-contractor and issue a proper Form 1099-NEC.
It’s really important you follow federal and state rules between employees and contractors and not try to force the issue to give them a 1099. You can easily fall prey to an employment audit with your children if they act, look, and smell like an employee, but you ‘call’ them a sub-contractor. Be careful. (See my article “1099 Rules for Business Owners” for more information on when and how to issue the 1099-NEC.)
Remember, the goal is to pay them for legimitate services BECAUSE you are helping them with life expenses. Why? so they can pay taxes in their ‘lower bracket’ with money you were going to give them anyway!!
Over the years, I have seen three primary ways you can involve your adult children in your business. In fact, I have used ALL three of these strategies with one of my adult children at one point or another. Consider these working relationships:
- Have them serve as a marketing consulting and service provider off-site. This could simply be providing occasional marketing or management support, or day to day social media posts, or graphic design.
- Have them serve on the Board of Directors in your corporation or the Board of Advisors in your LLC. This is extremely common and great support to business owners and also a tool to teach the children about the business. See my article “Setting up Your Board of Directors or Advisors”
- Have your children serve as property managers of your rental property in the area in which they live. This could even be rental property they are actually living in while going to college.
Let’s summarize what all the benefits could be by hiring your children in the business:
- You get a tax deduction for paying your kids money you were going to give them anyway
- Your children still don’t pay income taxes on the first $12,550 of income this year in 2021
- IF the children do pay taxes (young or old) they will typically do so at a lower rate than you
- This could be for an operational or online business or even rental property
- They don’t have to live near you to make it legitimate.
- Children learn about entrepreneurship
- And if you’re lucky, their help will actually make your business more successful and profitable.
I have seen these strategies not only save clients thousands of dollars in taxes and literally change the lives of their families. Children begin to learn work ethic and it can draw a family together in ways never fathomed by small business owners.
As you can see, this is a BIG topic, but I break this down in Chapter 12 of the 2nd edition of my book “The Tax and Legal Playbook – Game Changing Solutions for the Business Owner”. Don’t give up and keep learning!! There are a lot of variables to consider when designing your healthcare strategy. The savings around every corner. Talk to your CPA and get a plan for this year before it’s too late.
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.