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Tax Benefits of Hiring your Children



Summary

Hiring your children to work in your business is an excellent write off against your business income, while also teaching your children about good work ethic and responsibility. The good news is the government is encouraging this behavior by providing additional tax incentives for certain individuals and businesses.


The Internal Revenue Code (IRC) explains how the services of a child under the age of 18 and works for their parent are not subject to Social Security and Medicare taxes. However, this rule only applies to business structured as a sole proprietorship, single member LLC taxed as a sole proprietorship, and a partnership in which each partner is a parent of the child [(IRC Section 3121(b)(3)(A)]. In addition, child under the age of 21 are also not subject to the Federal Unemployment Tax (FUTA) [IRC Section 3306(c)(5)]


The Three Myth’s


Myth 1: If you hire your children then their income will automatically disqualify the parent from claiming their child as a dependent.

The rules for claiming a dependent, not to be mixed up with a qualifying relative, are not conditional on a fixed dollar amount the dependent earns. However, it does state the taxpayer must provide more than half of their child’s support for the year [IRC Section 152(c)].


Myth 2: I can only pay my child up to the standard deduction ($12,550) because then they will be subject to federal taxes and/or the kiddie tax.

Dependents are subject to different rules when calculating their standard deduction. For 2021, a dependents standard deduction is limited to the greater of (a) $1,100 or (b) their earned income plus $350, but (c) not greater than the standard deduction.


Let’s say Jim’s dependent made $12,000 in W2 wages in 2021. The dependents standard deduction is $12,000 + $350 = $12,350. Thus, Jim’s dependent would have taxable income of zero dollars.


Now, assume Jim’s dependent made $13,000 in W2 wages in 2021. The dependents standard deduction would now be $12,550, leaving taxable income of $450.


What if I said you could pay your child up to $18,550 in wages without creating any federal taxable income for your child? To accomplish this all you need to do is setup a traditional IRA account for the child and make sure to deposit $6,000 to the child’s account. By maximizing the dependents traditional IRA contribution will reduce their adjusted gross income dollar by dollar, leaving only $12,550 for the AGI which is reduced by the standard deduction to give your dependent taxable income of zero dollars.


Finally, the Kiddie Tax, which subjects a child’s income over a threshold amount to the tax rates of the parent, only applies to unearned income [IRC Section 1(g)]. W2 income is ordinary income or also known as earned income. Thus, the Kittie Tax does not apply to ordinary income.


Myth 3: My business is operating as a S-Corporation or a C-Corporation, so I do not receive the benefit of not paying FICA taxes.

It is true corporations cannot receive this tax benefit, however there are ways to legally work around this issue by simply creating a “buffer”. The general idea is to create a Family Management company that is owned by one or both parents. This sole proprietorship or limited liability company will be responsible for paying your dependents wages while the corporation pays a management fee to the company. See the diagram below for an illustrated example.


What Not to Do

In Ross v. Commissioner, TC Summary Opinion 2014-68 there was a mother who claimed a wage deduction on her three children who were reported as employees on her tax return. However, when the IRS reviewed the taxpayers documents they found no record of a paycheck being issued to them and no history of any hours being recorded. The IRS ultimately denied her deduction.


Just make sure to treat your dependent as an employee of the company. Make sure you are tracking their hours, paying them a wage, and make sure you can clearly document the payment. Lastly, always make sure you are following all labor laws in your state.


Conclusion

This is just a summary of the tax planning strategies that exist which can help you save some money on your taxes while teaching your child about hard work and the value of money. It is very easy to incorrectly use these tax strategies which is why I always recommend you have a qualified tax professional, preferably your outsourced accountant, on your team to maximize your tax savings. Contact Marlow Accounting today and schedule your first free consultation to get you on the path of paying your fair share in taxes, and not a penny more.

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