If you run your own business, your children can be a great tax savings device. If you hire your children as employees to do legitimate work in your business, you may deduct their salaries from your business income as a business expense. Your child will have to pay tax on the salary only to the extent it exceeds the standard deduction amount for the year. Moreover, if your child is under 18, you won’t have to withhold or pay any FICA (Social Security or Medicare) tax on the salary (subject to a couple of exceptions).
These rules allow you to shift part of your business income from your own tax bracket to your child’s bracket, which should be much lower than yours (unless you earn little or no income). This can result in substantial tax savings.
However, the IRS is well aware of the tax benefits of hiring a child, so it’s on the lookout for taxpayers who claim the benefit without really having their children work in their businesses. If the IRS concludes that your children aren’t really employees, you’ll lose your tax deductions for their salary and benefits. And they’ll have to pay tax on their benefits. To avoid this, you should follow these simple rules.
Rule 1: Your Child Must Be a Real Employee
First of all, your children must be bona fide employees. Their work must be ordinary and necessary for your business, and their pay must be for services actually performed. Their services don’t have to be indispensable, only common, accepted, helpful, and appropriate for your business. Any real work for your business can qualify. You get no business deductions when you pay your child for personal services, such as babysitting or mowing your lawn at home. On the other hand, money you pay for yard work performed on business property could be deductible as a business expense.
There are probably lots of things your child can help you with, such as answering phones, helping with your website, stuffing envelopes, or cleaning the office.
The IRS won’t believe that an extremely young child is a legitimate employee. How young is too young? The IRS has accepted that a seven-year-old child may be an employee but probably won’t believe that children younger than seven are performing any useful work for your business.
You should keep track of the work and hours your children perform by having them fill out timesheets or timecards. You can find these in stationery stores or make a timesheet yourself. It should list the date, the services performed, and the time spent performing the services. Although not legally required, it’s also a good idea to have your child sign a written employment agreement specifying his or her job duties and hours. These duties should be related only to your business.
Rule 2: Compensation Must Be Reasonable
When you hire your children, it is advantageous (tax-wise) to pay them as much as possible. That way, you can shift as much of your income as possible to your children, who are probably in a much lower income tax bracket. However, you can’t just pay any amount you choose: Your child’s total compensation must be reasonable. Total compensation means the sum of the salary plus all the fringe benefits you provide your spouse, including health insurance and medical expense reimbursements, if any. This is determined by comparing the amount paid with the value of the services performed. You should have no problem as long as you pay no more than what you’d pay a stranger for the same work—don’t try paying your child $100 per hour for office cleaning just to get a big tax deduction. Find out what workers performing similar services in your area are being paid. For example, if you plan to hire your teenager to help answer the phone, call an employment agency or temp agency in your area to see what these workers are being paid.
To prove how much you paid (and that you actually paid it), you should pay your child by check, not cash. Do this once or twice a month as you would for any other employee. The funds should be deposited in a bank account in your child’s or spouse’s name. Your child’s bank account may be a ROTH IRA, Section 529 college savings plan, or custodial account that you control until your child turns 21.
Rule 3: Comply With Legal Requirements for Employers
Finally, you must comply with most of the same legal requirements when you hire a child as you do when you hire a stranger. This means you must fill out IRS Form W-4 and complete U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. You must also record your employee’s Social Security number. If your child doesn’t have a number, you must apply for one. In addition, you, the employer, must have an Employer Identification Number (EIN). If you don’t have one, you may obtain it by filing IRS Form SS-4. You must also complete and file IRS Form W-2 showing how much you paid your child. For details, refer to the the Hiring Employees FAQ at the Nolo website.