You may have heard that you can hire your children as a legitimate way to reduce tax liability. This recommendation may seem like an appealing way to save on taxes and start teaching your kids about business. However, there are complex considerations to weigh before determining if it is the right choice for you and your business.
The idea behind this strategy is to shift income from the business, which likely falls in a higher tax bracket, to the child, who likely falls in a lower tax bracket. The business receives a deduction for the wages paid and the child recognizes the income. If your child earns less than the standard deduction, they may owe no taxes on those wages nor need to file a tax return. These wages may also serve as a way to start building savings for your child. They can be contributed to an individual retirement account (IRA) in your child’s name, such as a Roth IRA. In these accounts, earnings can grow tax-free.
However, the devil is in the details. Business owners should consider the following before determining if hiring their kids makes sense for them:
Tax Entity Classification
Employing your children works best for sole proprietorships and single member LLCs which file Schedule Cs. If your business files taxes as an S corporation or C corporation, you must pay Social Security, Medicare, and Federal Unemployment taxes on your child’s wages. This may offset most of the tax savings. It’s important to consider your specific entity classification to determine if hiring your child makes sense.
Federal & State Labor Laws
Labor laws allow children to work for their parents. Nonetheless, there are rules regarding what type of work can be done and by whom. This includes regulations regarding the child’s age, the number of hours worked, reasonable compensation, and the type of work that can be performed. These rules vary by state but generally seek to ensure working conditions are safe. Further, they aim to ensure that the child’s education is not compromised. Understanding and complying with child labor laws is essential. Therefore, clear documentation should be maintained outlining the child’s responsibilities and schedule.
Because it is a popular tax-saving strategy, employing a child in the family business may increase the risk of being audited by the IRS. Making sure your fact pattern is reasonable greatly reduces the risk of raising red flags. If the IRS determined your child did not qualify as your true employee during an audit, you’d owe back any tax savings plus penalties and interest. Therefore, businesses must be prepared to substantiate the legitimacy of the work tasks being performed by their children.
In the right situation, employing your child may be a very beneficial arrangement for you and your family. Nevertheless, it is important to have a clear understanding of the implications of this strategy. Our team of experts navigates the complexities of these tax laws every day. We are here to help tailor a solution that meets your unique situation while complying with applicable tax laws and regulations. If you are considering hiring your children or are just seeking professional guidance on ways to reduce your tax liability, we’re here to help. Our team of experienced CPAs can provide the expertise you need to make informed decisions and optimize your tax efficiency. Contact us today to arrange your complimentary consultation.