If your children, young or old, worked for you in 2020 and you haven’t properly processed paying them, it’s important you get this taken care of before year-end.
Paying family members for working in the business has to be one of the most underutilized tax strategies by small business owners with families today. Many don’t realize that properly paying their children 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 $12,400 of income this year in 2020! (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 $12,400!
Make sure they Earn It and Following the Rules
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 or legitimate work and services. 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 you pay your children as a ‘sham’ operation. 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).
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 not penalty…and thus the W-2 is perfunctory. The IRS doesn’t care. The only time we recommend a W-2, is if you plan to have your child contribute to a Roth IRA (a great strategy!). This way the IRS computer matches up the kid’s contribution with 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. 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), pay a legitimate management fee from the Corporation, or simply pay them out of a Sole-Proprietorship or LLC with independent income and operations.
Paying Your Kids 18 or older
This is a very important and powerful strategy if you are continuing to ‘support’ or ‘get the help’ of your children as adults in the operation of your business. Essentially you have two options, 1) pay them as an employee with all the other ‘rank and file’, or 2) pay them as a sub-contractor.
CAUTION: If your adult children act as an ’employee’ then treat them as such. You want to follow the state and federal rules on the differences between employees and contractors and not try to force the issue and give them a 1099. You can easily fall prey to an employment audit with your children if they act, look like and are treated like an employee.
However, if your adult children are serving on your Board of Directors in your corporation or Board of Advisors in your LLC, or simply providing some occasional marketing or management support, they will more than likely qualify as a sub-contractor. See my article “Setting up Your Board of Directors or Advisors”. Now you can validly issue them a 1099.
You get a tax deduction for paying your kids to help with the business, rather than paying taxes at your rates. Your children still don’t pay income taxes on the first $12,400 of income this year in 2020! (See TCJA and increase in the Standard Deduction. Rev Proc 2011-52, Sec. 3.11(1), 2011-45 IRB). However, if you issue them a 1099, don’t forget this makes them a small business owner themself with all the write-offs of being an entrepreneur. Remember, this is a good thing, not a bad thing.
I have seen these strategies not only save clients thousands of dollars in taxes, but 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.