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The idea of hiring your kids is a commonly shared tax savings strategy, BUT most business owners have trouble implementing this trick. The reason it is so complicated is in the nuances of how to navigate State and Federal tax laws to avoid paying any unnecessary payroll and income taxes.
So, spoiler alert: it is NOT as simple as just cutting your kids a check. Read on for the real and correct way to do this.
It helps to know that in 2021, the standard deduction for all taxpayers is $12,550 for single taxpayers, and $25,100 (twice the single) for those filing jointly. This means the first dollars that someone earns up to the standard deduction are earned tax-free. Think of it as a head start before the government starts keeping track of your income. This applies to kids too. Also, note that this standard deduction changes every year, so before you write down those numbers, do a quick google search on what the current standard deduction is.
Why is this a good idea?
The intent is to minimize the taxable income entering the household. This is a tax avoidance (not evasion!) strategy commonly used to shift income from parents to children. This is also a helpful vehicle to teach your children about how money and employment work, and to help them start saving. what better way to teach than to immerse them in a real life job scenario? If you're thinking "jeez, I wish my parents did this for me," then you are not alone and this is a great way to accelerate your kids' experience with money.
What conditions must be present to do this?
First, understand that the ideal age to take advantage of this strategy is 7-17 years old. The child must be under 18. If your child is under 7, the Social Security Administration will require more support for the type of work performed. You also want to pay particular attention to your state labor laws and make sure you are not in violation of any rules. I do know a few infant models for baby clothes, though... just saying.
There must be legitimate work and legitimate pay for the work, and the work must be age-appropriate. The facts need to line up and it needs to hold up in an audit. Hiring your toddler to drive deliveries to customers is definitely not going to hold up. However, hiring your 8-year old to file paperwork alphabetically or hiring your teenager to respond to DMs on your social media do make sense.
You must also factor in the other income sources of the child when evaluating if this will save you money in taxes and how much. If we are talking about a 16-year old who also works a part-time job, then this is still a potential strategy but the "tax-free" component is not exactly true because the child may earn more than what can be deducted, thus paying tax on the income. You want to try to stay at or below $18,550 per child. You'll see why later.
Can I do this no matter the type of business entity I have?
Yes and no.
The child MUST be directly paid from a sole proprietorship ("sole prop") or LLC owned by one or both parents. Don't bail on me, S Corp owners... we got something for you too.
How do S Corp owners get around this? Have the S Corp hire your family office company (sole prop / LLC) that you establish and have the family office company hire the child onto payroll.
Why not pay them directly from the S Corp? Because then you would be required to pay the 15.3% payroll taxes on the income, making it less effective as a tax strategy.
We should mention that you will have to run payroll, so if you currently have no employees in your business, this will be new territory. Payroll can run your business from $30-100+ a month depending how many employees you have and what benefits you offer. remember that is just for the service.
So, how does this save in taxes?
Okay, math time.
Say your 15-year old daughter works for you doing some basic bookkeeping or helping you navigate your TikTok account. Let's say you give her enough work to pay $20/hour for 10 hours a week, which equates to roughly $800-1,000/month. Let's call it $1,000 a month with a couple extra hours in there. That means $12,000 a year - voila!
If you stop at that, your daughter has made $12,000 in income (assuming she makes no other income) and therefore, the standard deduction wipes out all of the taxable income. In addition, you get to take this payroll expense on your tax return, which reduces your business profit.
Now let's also say that you pay her for other projects like updating your website or making calls for you. You wind up paying $1,530 a month for her to do a variety of services for you. That adds up to $18,360 a year.
Buckle up for this one.
You can deduct NOT ONLY $12,550 in the standard deduction, but an ADDITIIONAL $6,000 if the child also contributes to a traditional Individual Retirement Account (IRA). This means that you can pay the child up to $18,550 in the tax year and have it all be wiped from taxable income.
Keep in mind there is no expectation to always maximize this. If you can, great. It is still beneficial, however, to pay them any sum under the standard deduction to reduce taxable income, even if by a little.
But, what about payroll taxes?
Per the IRS, payments made in wages to a child under 18 are not subject to payroll taxes. This means both the employee and employer share of payroll taxes are waived, and you just need to focus on income tax.
What can you do with the money they earn?
Once the money is shifted to the child, they can contribute to retirement savings, investments or a 529 college savings plan. I happen to love the idea of the 529 because what better way to educate kids about money and then have that whole experience fund higher education itself? Of course, this will depend greatly on whether the child has the desire or the parents encourage attending certain educational institutions. In summary, the money is available to help the child invest in their future.
I'm ready to do this. What do I need?
First, start with planning. Make sure that this approach is acceptable for the age and skill set of your child and your state labor laws. You will want to sit down and map our what work the child will do, how much they will get paid, etc. You will want to document this in a formal employment agreement between the child and the sole prop/LLC paying them. If you are an S Corp owner, you also want to establish a contract between the S Corp and the sole prop/LLC for the contracted work. Make sure all the relationships are documented and clear. Hire a lawyer to assist with this if needed.
Open your child their own checking account in their name. Make sure the business pays into their checking account when payroll is run, so it does not look like a routine owner's draw into your bank account.
You will also want to enroll in payroll services. We recommend Gusto. You can get set up in minutes and run payroll within a week with the right guidance.
Create a time and work tracking system. Document their hours and what was accomplished. If they have a specific deliverable as part of their work, like a report, save it as well in case it is ever needed for an audit. This could be as simple as a spreadsheet, but Gusto also has an hours tracking feature as well.
Of course, we recommend seeking professional advice when implementing this to ensure this strategy meets your goals and objectives, both in the business and personally. If you are looking for assistance in implementing this and other strategies, book a call with us.