Tax Benefits and Detriments of Hiring Family Members
Tax Benefits and Detriments of Hiring Family Members Social media is abuzz with armchair tax professionals that are promoting the tax savings technique of putting family members on payroll. Let’s take a quick look at the benefits that can be gained and highlight some of the possible fallouts and how to mitigate the risks that[...]
Tax Benefits and Detriments of Hiring Family Members
Social media is abuzz with armchair tax professionals that are promoting the tax savings technique of putting family members on payroll. Let’s take a quick look at the benefits that can be gained and highlight some of the possible fallouts and how to mitigate the risks that can arise.
The kiddie tax is a special tax rule that applies to a child’s unearned income. This law taxes such income of a dependent child at the parents’ marginal tax rate, subject to certain thresholds, and Congress passed this legislation in order to discourage individuals from transferring assets to their children to take advantage of their lower tax rates.
However, the kiddie tax only applies to investment income e.g. interest, dividends and capital gains (also known as “unearned income”). A taxpayer’s “earned income” refers to salaries, wages, tips and professional fees. If a child has earned income it is taxed at the child’s tax rate. Therefore, there is an opportunity for significant tax benefits if the earned income is below certain thresholds. In addition, if the payor of the earned income is the child’s parent, there are additional tax benefits available.
Tax Benefits for Hiring Family Members
The magic number for tax benefits is the standard deduction. The standard deduction is defined as a specific dollar amount (adjusted annually for inflation) that reduces the amount of income on which you are taxed. This can also be understood as a floor amount of income, below which taxpayers do not pay any income taxes. For 2024, the standard deduction for a dependent child’s earned income is $14,600, which means that if a minor child’s “earned income” is equal to or lower than this amount, there is no income tax on that income, and the income may not even have to be reported on an income tax return (this will save the tax return reporting fees paid to your tax preparer).
The business that pays the wages gets a deduction for that expense. Therefore, if you have a business, adding your minor child to payroll will garner the following tax savings:
- Income Tax Savings:
- Wages paid to family members are tax deductible for the business; the tax savings will be equal to the marginal tax rate of the business owner.
- The wage income that is below the standard deduction is income tax free to the child recipient (and it is not reportable either).
- Payroll Tax Savings:
- If the business is a sole proprietorship owned by one of the child’s parents, or a partnership that is wholly owned by both of the child’s parent(s) (i.e. no third-party ownership and the child is under age 18 (age 21 for FUTA), both the employer (parent) and employee (child) are exempt from payroll taxes; this is a tax savings of ~15%.
- If the business is a corporation (either C or S corporation), then the business and the child would still be subject to payroll taxes for the child employee.
- There is a possible workaround to gain exemption from payroll taxes for businesses that are corporations or that are not solely owned by parent(s) – a management company can be setup that charges a legitimate management fee to the operating business, and this management company would enter into agreements with the child to hire the child and have the child on payroll to save the payroll taxes.
There is yet an additional financial benefit; because the child has “earned income” the child can contribute these tax-free earnings into a tax-free ROTH IRA and the funds will continue to grow tax free. Considering the compounding interest on annual deposits for the years in which the child is working for the parent, this can help the child build a basic tax-free nest egg before he/she even turns 18. The amounts that this account can earn by the time the child turns 72 can be quite significant.
If the wages paid to the child are more than the standard deduction, the amount of wages above the standard deduction would be taxable income to the child. The child can make a tax-deductible contribution to a traditional IRA to reduce his/her taxable income. The money continues to grow in the account tax free, but will be taxable upon retirement, and subject to the RMD (required minimum distributions).
Now that we have explained the basic tax benefits of hiring family members, let’s take a dive into the potential pitfalls, and what can be done to mitigate the audit risks associated with this strategy. The issue at hand is that an IRS examiner may view this working relationship as more familial, and that ostensibly, no real work was performed. Were that to be the case, then the wage deduction would be disallowed, giving rise to additional taxable income. This tax liability on such income would then be subject to late payment interest and penalties.
- Merely putting a family member on payroll to pay their allowance and get a deduction can ultimately come back to bite you if it is ever audited. The wages would have to be for the following:
- Bona Fide Work for the Child – in order for a potential IRS agent auditing this strategy to signoff with no change, the tasks that are being performed by the child must be legitimate and documented properly. Pretending to have the child work just to obtain the benefits will not pass the smell test.
- Bona Fide Work for your Business – having the child do work that is not in-line with the needs of your business will also fail the smell test e.g. paying the child for household chores.
- Age Appropriate – tasks have to be appropriate to the specific child. Having an eight-year-old balance the books would be egregious, but the same eight-year-old can do some company car cleaning, cleaning and wiping down monitors in the office, vacuuming, passing out fliers. Another type of job that parents find useful is to employ their child to be model to use as a means of business advertising and promotion, depending on the nature of the business.
- Reasonable Compensation – the wages must be fair for that type of work. Better off paying less (e.g. minimum wage) to avoid the risk of it being disallowed, rather than paying more to maximize the tax benefits.
- Child Labor Laws
- Federal child labor laws were enacted to ensure that young people are able to work in a safe environment. Certain types of work or environments are unsafe and therefore illegal to have employees that are minors e.g. meat processing and slicing, power driven bakery machinery, power driven contracting machinery, manufacturing, excavation, etc.
- State child labor laws may have additional restrictions besides the basic federal provisions enacted to protect young workers. We recommend contacting an attorney that specializes in labor law to ensure that hiring your child, at his specific age, is not prohibited under local law, before implementing this type of strategy.
- Employment insurance – you may need to have a worker’s comp policy for your child.
- Documentation – the best recommendation is to document e.g. employment agreements, image agreements (for child models), management company agreements, retaining a completed Form W-4, filing of Forms W-3 and W-2, document your child’s work hours and include dates and detailed descriptions of tasks performed, deposit the wages into the child’s personal bank account.
Owners of closely held family businesses introduce their children into the workforce at a young age. This can be beneficial from the perspective of business succession planning as well as to help their child with personal development (i.e. teaching responsibility, self-discipline and the ability to manage a work schedule) as well as skill development (e.g. problem solving, interpersonal skills, financial and business acumen).
Hiring your child to work for your business also has tax and financial benefits. These items, discussed above, include income and payroll tax savings and incentives, and the ability to invest those savings in tax free or tax deferred accounts where the money remains preserved for retirement. Collectively, this results in a unique manner of asset transfer to the next generation, and wealth building.
Child Labor Laws and Parents – site contains links highlighting the tasks that child laborers are allowed to do broken down by age; businesses which are owned solely by the child’s parents have more flexibility which is another reason to use a management company when the business is owned by different branches of a larger family.
Fasten Halberstam LLP – keeping you informed where it matters.