Have you ever considered employing your children? You and your children could benefit from hiring within the family. Paying your children for services performed in your family business can reduce your overall family tax bill, while shifting assets to your children without gift tax implications. Your children can also gain valuable work experience and develop work ethic. Recent tax reform has made this tax-saving strategy more attractive than ever before.
How Does This Work?
As a business owner, you pay your child to work for you in your business and you deduct the wages paid from your income, while your child pays zero to little tax. In doing so, you may shift part of your business income from your own tax bracket to your child’s tax bracket.
Recent tax law changes have nearly doubled the standard deduction, now capped at$12,000. This means that one of your children could earn up to $12,000 in W-2 wages and pay zero income tax. If they earn more than $12,000 a year, they would be required to pay income tax, but at a much lower tax rate.
For example, if a child earns $21,525, they would only pay $925 in Federal income tax.
- ($21,525 Earnings – $12,000 Standard Deduction) x 10% Rate = $925 Tax Due
In turn, you get to deduct the $21,525, reducing your taxable self-employment income.
- $21,525 Deduction x 40% Rate = $8,610 Tax Savings
Overall, your family receives tax savings of approximately $7,685.
- $7,685 Tax Savings = $8,610 (Parent’s Savings) less $925 (Child’s Tax Paid)
If your children have W-2 earnings, they can contribute to Roth IRAs. If your children contribute at an early age, their funds will be in the account for a long time, allowing for long-term tax-free growth, and ultimately, tax-free withdrawals. Current IRS rules allow the actual contributions to be made by a parent or grandparent, so your children are free to save or spend their earnings.
If your business is a sole proprietorship or husband-and-wife owned partnership, you are entitled to yet another benefit. If your child is under age 18, no Social Security or Medicare taxes need to be paid on the child’s earnings. Please note that, unfortunately, corporations and non-spouse partnerships do not qualify for this exemption from payroll taxes; however, they, too, may be eligible for other types of tax benefits.
Remember these Rules
The following rules must be observed to benefit from this strategy:
- Your child must be a bona fide employee.
- The amount paid must be reasonable, considering age and responsibilities.
- Proper paperwork for the child as an employee must be maintained.
As you can see, this can be an incredibly effective tax strategy with both financial and professional benefits for you and your children. If you would like to discuss this strategy or others, please contact us to review the tax saving options that will best suit your family business.