For many parents who own small businesses, two of their primary goals are passing on a strong work ethic to their children while also lowering their tax bill. While lower taxes typically start the conversation, parents often realize that the largest benefit is the impact the work experience has on their children as they learn the value of a dollar and the importance of hard work – qualities that are more difficult to teach in modern society.
In the mid-1800s when Abraham Lincoln established the Department of Agriculture, 90 percent of Americans were farmers. With farm life came the normal expectations that children would begin helping with the ongoing farm labor as soon as they were capable.
This expectation created opportunities to develop a strong work ethic and provided a foundation for responsibility and success as adults. Over the years as Americans have migrated from rural communities to larger cities, most parents spend their time in jobs that are disconnected from their family life.
As a result, children are not automatically involved in helping their parents provide for the family and don’t have the chance to learn the work ethic that is invaluable as they transition to life on their own.
To compensate, many parents are looking for ways to start creating a work ethic in their children. While many parents who work for a large employer may not have the option to hire their children directly; others who own small businesses may find that employing their children can be a great way to start building that work ethic while also receiving tax benefits themselves.
Child Labor Restrictions
While child labor laws place age-based restrictions on work activities for children when working for an unrelated employer, there is a general exception to age restrictions for the work activities of a child in a business owned solely by his/her parents (assuming the work is not in a hazardous occupation).
It is important to note that this parental exception allowed by federal law is allowed specifically because lawmakers assume that parents are primarily concerned for their children’s wellbeing and will ensure the child is not placed in a dangerous environment.
Accordingly, the exception is only applicable when one or both parents are the only owners of the entity. If there are other owners, the exception no longer applies [Department of Labor Wage and Hour Division Field Operations Handbook Chapter 33e00(a)(4)].
While federal law provides an exemption for children working for their parents, it is also important for parents to review and understand any state and local laws in effect where they live.
Key Takeaway:
There is an exception to age restrictions for work activities of a child as long as the only owners of the business are the child’s parents.
Potential Tax Benefits of Hiring Your Children
Parents who are the sole owners of their small businesses often look for ways to hire their children to begin teaching them responsibility while also achieving significant tax benefits.
The first tax benefit for parents from hiring their children is that their children are entitled to their own standard deduction. This means that in 2024, the first $14,600 paid to a child for work in the family business will be free of any federal income tax to the child!
Parents who are familiar with the “Kiddie Tax ” will be happy to know the Kiddie Tax (which requires that certain income be taxed at the parent’s tax rate) only applies to unearned income such as interest and dividends. Income paid to the child for work within the family business is considered “earned income” and escapes the Kiddie Tax provisions. Thus, the earned income is taxed to the child instead of the parents.
An additional tax benefit for parents hiring their children is that Social Security, Medicare, and federal unemployment taxes can also be avoided in certain cases. The treatment of Social Security, Medicare, and federal unemployment taxes is dependent upon business type and the age of the child.
Key Takeaway:
A child’s income could be tax free up to $14,600 and in certain cases, can also avoid Social Security, Medicare, and federal unemployment taxes!
Children Under Age 18
When a parent chooses to hire a child who is under age 18, the Social Security, Medicare, and federal unemployment tax consequences are driven by the type of business the parents have established.
In unincorporated entities such as sole proprietorships or partnerships where one or both parents are the sole owners of the entity, payments to the child are not subject to Social Security and Medicare taxes. Further, the wages of the child are not subject to federal unemployment taxes until the child is age 21.
From a Medicare and Social Security tax perspective, this represents an additional 15.3% tax savings on the wages paid to the child since both the employer portion (7.65%) and the employee portion (7.65%) of Medicare and Social Security tax is avoided.
If the business entity is a corporation (e.g. either a C-Corporation or an S-Corporation), a partnership where all partners are not parents, or an estate, payments to an owner’s child require all the typical Medicare, Social Security, and federal unemployment tax withholdings. While the benefit of avoiding these payroll taxes is lost, the benefit of the child’s standard deduction to shield the wages from income tax remains.
Key Takeaway:
A child under age 18 working in a sole proprietorship or partnership solely owned by their parents can avoid Social Security and Medicare tax withholdings.
Children Age 18 or Older
Once a child reaches age 18, all payments for services are subject to the typical Medicare and Social Security withholding rules that would be applicable to a standard employee.
If the business is a sole proprietorship or partnership where the only owners are parents of the child, the child remains exempt from federal unemployment taxes until age 21. Federal unemployment taxes are 6.0% of the first 7,000 of wages.
Once the child turns 21, federal unemployment taxes must be paid as well.
Key Takeaway:
Once the child turns 18, they will be subject to Medicare and Social Security withholdings, but the child may still be exempt from unemployment taxes until the age of 21.
Potential Tax Savings
Given a portion of the tax savings from hiring children in the family business comes from each child having their own standard deduction, the more children a family has, the larger the potential tax benefit.
To demonstrate the value of this strategy, consider the following example. We will assume a family has three children who are all under age 18. The business is a sole proprietorship owned by one of the parents, and each child earns $10,000 during the year.
We will also assume the parents are in the top federal tax bracket of 37% and have an additional state tax rate of 5%.
In this scenario, the parents receive a $30,000 tax deduction for the wages paid to their children which reduces the parent’s tax liability by $30,000 x 42% (37% Fed + 5% State) for total tax savings of $12,600 per year (plus some minor payroll tax benefits).
On the children’s side, they will each receive $10,000 and will owe no federal income tax (assuming this is their only income) because their own standard deduction would be sufficient to fully offset this income.
Additionally, the children and the parents will not be required to pay Social Security, Medicare, or federal unemployment taxes. As a result, the parents have managed to shift $30,000 of taxable income from themselves and transform it into tax-free income for their children.
The following calculation demonstrates the tax savings and includes the assumption that this couple is past the Social Security wage threshold and only owes Medicare taxes (including the additional Medicare tax) but not Social Security tax on any additional self-employment income.
As the table shows, the total tax savings for the family would be $13,740.
If this example were changed and the parent’s business was an S-corporation, the tax savings would also change.
First, the parents would still save $12,600 in income taxes, however given the entity is an S-corporation, they would already avoid the Medicare and additional Medicare tax on any profits within the business. Accordingly, the tax savings for the parents would be limited to $12,600. In addition, the family would be responsible for Social Security, Medicare, and federal unemployment taxes for any payments to the children which would partially offset the $12,600 of tax savings for the parents.
The final result is the family as a unit still saves $6,750. While not as tax-efficient as a sole proprietorship or partnership solely owned by the children’s parents, there still are tax savings available for a family with an entity structure that requires Social Security, Medicare, and federal unemployment taxes to be withheld.
Since many parents are already planning to pass assets along to their children, either through inheritance or helping with expenses during life, hiring children within the family business is often a tax-efficient way to begin the process.
Key Takeaway:
While not as advantageous, tax savings can still be available in situations where payroll taxes must be withheld.
Can I Just Write My Kids a Check?
While the IRS allows parents to hire their children within the family business, they also understand that the tax savings can entice parents to add their children to payroll without giving them legitimate jobs or paying them a reasonable wage.
In order to effectively implement this strategy, parents must ensure they are complying with the rules and regulations that Congress has put in place. Otherwise, they run the risk of being challenged by the IRS.
A general rule of thumb that parents should consider when hiring their children is to treat them like any other employee. In other words, hire them for a legitimate task that is necessary for the business, pay them a reasonable wage based on their time, effort, and experience, and follow typical reporting requirements.
Legitimate Work: In historical cases where the IRS has challenged parents who hired their children, the parent is responsible to demonstrate the work performed by the child. Accordingly, keeping quality documentation and time sheets of the work performed and the time associated with that work is important.
Additionally, it is important that the tasks the child is performing are business-related tasks rather than tasks that can be classified as routine family chores such as mowing the yard, taking out the garbage, etc. Parents should plan on hiring their children only for services that are ordinary and necessary for the business (i.e. services that need to be completed regardless of whether they hire their children).
Reasonable Wage: Similar to ensuring that the work performed is legitimate, the amount paid to the child must also represent a reasonable wage for the time, effort, and expertise that is required.
Paying a child $300 per hour to clean the office each week is unlikely to pass the reasonable wage threshold whereas paying them $20 per hour will be easier to explain.
In addition to paying a reasonable wage, it is important to ensure that the amount paid to the child is directly related to the work performed. In prior court cases, parents have paid children a flat amount through the year and then, when challenged, tried to show that the wages were tied to hourly work.
However, if each child is paid the exact same amount despite working different hours (especially if that amount matches the standard deduction), the taxpayer will have difficulty demonstrating the payment was clearly tied to the work performed.
Also, if payments occur over the course of the year, but the work only occurs during the summer months, the IRS is more likely to argue that the payments are a family allowance rather than payments for work performed.
Reporting Requirements: When hiring a child in the family business, keeping the typical reporting formalities helps demonstrate to the IRS that the job performed and wages paid are legitimate.
Keeping appropriate time sheets to document the completed work is imperative. Additionally, having children fill out W-4 forms to elect the appropriate withholding amounts and issuing W-2 forms at yearend are important to demonstrate the formality of the work relationship.
Key Takeaway:
Parents must ensure that they hire their children for a legitimate task that is necessary for the business, pay them a reasonable wage, and follow typical reporting requirements.
Family Management Company Strategy
In the examples above, parents who owned sole proprietorships or were the sole owners of partnerships realized almost double the savings of parents who owned corporations or had other partners. This was because they were able to avoid the Social Security and Medicare taxes on wages paid to children under age 18.
Often parents who own corporations or are partners in partnerships that include other individuals will ask whether there is a way they can structure their business activities to avoid Social Security and Medicare taxes. The answer is maybe.
To start, there is a structure that can accommodate this, and it involves setting up a family management company. The family management company is typically a sole proprietorship owned by one of the parents. The family management company then contracts directly with the corporation or partnership to provide services. The corporation pays the family management company a fee for the services and the family management company hires the owner’s children and pays them to provide the services.
While this strategy provides a way to pay children through a sole proprietorship and avoid Social Security and Medicare taxes, the biggest challenge to this strategy is that it has to comply with the “economic substance doctrine.” The economic substance doctrine is codified in IRC 7701(o)(5)(A) which states the following:
“tax benefits…are not allowable if the transaction does not have economic substance or lacks a business purpose.”
Accordingly, parents will need to be able to demonstrate how the family management company has a legitimate business purpose beyond avoiding Social Security and Medicare taxes. Simply setting up a family management company whose only activity is providing services to a related entity is an aggressive strategy that could be challenged.
Parents who want to set up a family management company will bolster their case if the family management company provides services to multiple entities and particularly, if some of the services are provided to unrelated parties.
Further, parents who set up a family management company need to run the entity like the business that it is. This means documenting annual meetings, maintaining proper bookkeeping, and following the appropriate payroll procedures.
The key point is if you expect the IRS to respect the family management company as a business, you need to run it and respect it like a business as well.
Key Takeaway:
A family management company can help facilitate payroll tax savings, but for the strategy to work, it has to be a legitimate business rather than an entity whose sole purpose is to avoid taxes.
An Additional Benefit of Hiring Your Kids: Roth IRA Contributions
Albert Einstein is credited with the quote: “Compound interest is the 8th wonder of the world” and compounding is what has led to incredible fortunes for investors like Warren Buffett.
Those who understand the value of compound interest realize that one of the most important factors is time. Time allows seemingly small balances to grow to substantial fortunes.
This is particularly useful for children who have extremely long time horizons to let their money grow. By hiring their children, parents give them the opportunity to create earned income which is a requirement to make a Roth IRA contribution. Roth IRA contributions are limited to $7,000 per year (2024) or earned income, whichever is less. Children who have earned income from the family business can begin investing at a young age in a Roth IRA account that will grow tax-free for life.
As an example, imagine a child who works for their parents during the summer for 5 years from age 16 to age 20. Let’s assume the child makes $7,000 each year and invests the money in a Roth IRA account that grows at 10% per year until they retire at age 65.
If all they ever saved was $7,000 each year for those initial five years, their Roth IRA would grow to over $3,115,000 by age 65 and would be entirely tax-free.
As the chart above demonstrates, investing early is one of the biggest keys to long-term success, and providing opportunities for your children to earn money within the family business can give them a significant head start in preparing for their future.
Key Takeaway:
Children can use the money they earn working in the family business to start saving for retirement. Small contributions in their early years could result in a multi-million dollar, tax-free Roth IRA for retirement.
Conclusion
In recent generations as society has shifted away from rural life, there has also been a decrease in children’s ability to participate in their parents’ occupations. With less than two percent of Americans currently growing up on family farms, parents are looking for other ways to teach their children the value of hard work and responsibility.
For parents that own small businesses, employing their children is a great opportunity to pass on these values while also providing an opportunity to learn about the family business that puts food on the table and provides financial resources for the family.
Although passing along valuable lessons is already a significant benefit, reaping the tax savings of passing income from high-earning parents to children in low tax brackets can be the icing on the cake for many families. Adding to this is the ability to kickstart your children’s retirement contributions in a way that can provide millions in tax-free retirement savings later in life.
While nearly all parents want a better life for their children, often the best way to achieve this is to provide the opportunity to develop skills through firsthand, on-the-job experience. By providing these opportunities, parents will create a legacy that will impact their families for generations to come.
If you are interested in learning more about how to incorporate your children into the family business as well as helping them get started saving for retirement, we would love to connect to see if what we do is right for you.
