By: Anastasia Sturm, Staff Accountant, and Jill Moore, CPA, Senior Manager
One benefit of running your own business is the flexibility to hire your own family members. There are specific employer tax requirements for family member employees as opposed to regular employees.
Below outlines strategies, your business can utilize to benefit both the business and the family member, specifically, the children that work in your business.
Wages as a Deduction from Taxable Income When Paying Children in a Family Business
The IRS allows you to pay children under the age of 18 for services to a trade or business owned by his or her parent. These wages are not subject to the usual Social Security or Medicare taxes – provided certain criteria are met. This allows your business to take the wages as a deduction from your taxable income without paying payroll taxes. This is a significant benefit for your business, but don’t start paying your child $50,000 a year quite yet. It is important to know how you can use this benefit for your business without burdening your child with a huge tax liability.
When paying your child, consider keeping the annual wage less than or equal to the tax year’s standard deduction. This way, when your child files their individual tax return, it will bring their taxable income to zero, and they will not owe any additional taxes. Under current tax law, this would mean paying your child a maximum of $12,550, provided they don’t have other sources of taxable income. These other sources could include wages from other jobs, dividends, and interest earned. These income sources will affect the maximum you can pay your child without causing a federal tax liability. Keep in mind, the threshold for taxable income is lower in most states, so there likely will be a state tax liability.
IRA Contributions for Children of Family Businesses
An additional strategy you can utilize to benefit your child is IRA contributions. Unless your child has a significant amount of other taxable income, their earnings at your business make them eligible to contribute to a Roth IRA. This will create an excellent base for your child’s retirement, or it can also benefit them after graduating high school. Distributions from IRAs can be taken without penalty if the proceeds are used for higher education. Therefore, you can create a great savings plan for your child’s college expenses. If they do not attend college, their IRA can continue to grow for retirement.
IRS Requirements for Tax Benefits of Family Businesses
These benefits all sound great, but what’s the catch? The IRS has a few requirements for these benefits to apply to your business.
- Services must be for a trade or business and be a sole proprietorship or partnership in which each partner is a parent of the child.
- Additionally, your child must be considered a real employee and perform reasonable tasks. Their activity should be considered ordinary and necessary for the nature of your business. This can include a variety of activities, including filing, cleaning, and data entry. Your child’s wages should be reasonable in comparison to the wage you would pay a regular employee to perform the same work.
As mentioned earlier, the IRS has allowed this strategy to apply to sole proprietorships and partnerships, not corporations. If your business is incorporated, your child’s wages will be subject to payroll taxes just like everyone else. Though this is not as beneficial for a corporation, your business still reduces taxable income by deducting your child’s wages, and your child can still contribute to an IRA or reduce their tax liability to zero using the standard deduction.
When this strategy is utilized correctly, your business can increase tax savings, sometimes enough to cover the cost of your child’s wages! It’s also a great opportunity for your children to have flexible work throughout the year, make some extra money, and witness what your business is all about.
For more information about the tax benefits of hiring children in the family business, please contact a Blue & Co. Advisor.