Combined income and payroll tax can consume half the profit of a self-employed individual any given year. So if you’re a business owner you may want to consider hiring your children this summer to obtain tax breaks and other nontax benefits.
With some careful advanced planning, it may be possible to:
- Shift your higher taxed income into tax-free or lower taxed income
- Realize significant payroll tax savings (depending on the child’s age and how your business is organized)
- Allow for retirement plan contributions for the children.
The IRS is aware that employing dependents can result in substantial savings for businesses, so be sure to treat your child like a real employee (substantiate hours, issue a W-2, etc.), compensate them fairly, and comply with all legal requirements.
If your child is not treated like any other employee in a similar position, the IRS could potentially deem their wages as not ordinary and necessary, and disallow them as a deductible expense.
While this deduction can reduce your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable), the children employed in the family business can earn up to $12,200 (in 2019) at a 0% income tax rate.
For example, let’s say a business owner operates as a sole proprietor and their marginal federal tax rate is 32% tax bracket and state tax rate is 8%. He hires his 16-year-old son to help with office work on a full-time basis during the summer and part-time into the fall. The son earns $12,000 during 2019 and doesn’t have any other earnings.
Ignoring for simplicity the SE and state tax deductions the business owner saves $6,496 [federal tax of $3,840 (32% x $12,000), state tax of $960 (8% x $12,000), and SE tax of $1,696 ($12,000 x 92.35% x 15.3%)] in income taxes at no tax cost to his son, who can use his 2019 $12,200 standard deduction to completely shelter his earnings.
Exemption from payroll taxes
If certain conditions are met, your child’s wages are exempt from Social Security, Medicare and FUTA taxes in a parent’s unincorporated business (sole proprietorship), a partnership in which each partner is a parent of the child or a single-member LLC. Your child must be under age 18 for this to apply (or under age 21 in the case of the FUTA tax exemption).
Retirement benefits for your children
In addition to tax savings, your business also may be able to provide your child with retirement benefits, depending on the type of plan you have and how it defines qualifying employees. Also because your child has earnings from his or her job, they can contribute to a traditional IRA or Roth IRA. For the 2019 tax year, a working child can contribute the lesser of his or her earned income, or $6,000 to an IRA or a Roth.
The bottom line
Thanks to the Tax Cuts and Jobs Act, hiring your child can be a tax-smart idea with the newly increased standard deduction all without facing the Kiddie Tax (which only applies to unearned income). As long as the child employed in the business complies with both Federal Fair Labor Standards Act rules and state labor laws and is treated in a similar fashion to other employees in the same role, the hire-the-kid strategy will benefit all involved. If you have any questions about how these rules apply to your situation, don’t hesitate to contact us.