As the summer season approaches, you might be contemplating employing young individuals to work at your small business. Simultaneously, your own children may be interested in earning some spending money. By adding your child to the payroll, you could potentially save on both family income and payroll taxes. This arrangement could be beneficial for both parties involved.
Here are four tax advantages to hiring your child
1. Shifting business earnings
One way to reduce your tax burden is by transferring some of your highly taxed income to your child as wages for legitimate services rendered, resulting in tax-free or low-taxed income. To qualify as a business expense, the wages paid to your child must be reasonable and commensurate with the work performed.
For instance, let’s say you’re a sole proprietor in the 37% tax bracket. During the summer and part-time in the fall, you hire your 16-year-old son to assist with office work. He earns $10,000 during the year without any other income. By doing this, you could potentially save $3,700 (37% of $10,000) in income taxes, without any tax liability for your son. Furthermore, he can use his standard deduction of $13,850 for 2023 to reduce his taxable income.
Even if your son’s earnings exceed his standard deduction, your family’s tax liability will still be reduced. This is because any unsheltered earnings will be taxed at a lower rate of 10% instead of being taxed at your higher rate, leading to tax savings for the family.
2. Claiming income tax withholding exemption
Your business likely will have to withhold federal income taxes on your child’s wages. Typically, an employee may claim exempt status if they had no federal income tax liability the previous year and expect to have none for the current year.
However, exemption from withholding cannot be claimed if two conditions are met: 1) the employee’s income exceeds $1,250 for 2023 (including more than $400 of unearned income), and 2) the employee can be claimed as a dependent on another taxpayer’s return.
It’s important to note that your child is likely to receive a refund for some or all of the withheld tax upon filing a tax return for the year.
3. Saving Social Security tax
If your small business is not incorporated, you could also reduce your Social Security tax burden by transferring some of your income to your child. This is because the services rendered by a child under 18 while working for a parent are not considered employment for FICA tax purposes.
Likewise, a more lenient exemption applies to the FUTA (unemployment) tax, which excludes earnings paid to a child under 21 who is employed by their parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of their parents.
It’s important to keep in mind that no FICA or FUTA exemption exists for employing a child if your business is incorporated or if it is a partnership that includes non-parent partners. However, if you’re compensating a child for work that you would have paid someone else to do, there’s no additional cost to your business.
4. Saving for retirement
Depending on the type of retirement plan your business has and how it defines eligible employees, your child may also be eligible for retirement savings. For instance, if your business has a SEP plan, you may make a contribution for your child of up to 25% of their earnings (not exceeding $66,000 for 2023).
Keep in mind that some of the rules about employing children may change from year to year and may require your income-shifting strategies to change too.