Big Tax Breaks for Hiring Your Children in the Family Business
- Child Under the Age of 19 or a Student Under the Age of 24
- Kiddie Tax
- Tax on a Child’s Earned Income
- Deduction for the Business
- Employment Taxes
- IRAs and Retirement Plans
With jobs at a premium during the COVID-19 pandemic, you might consider hiring your children to help out in your business. Financially, it makes more sense to keep the family employed rather than hiring strangers, provided, of course, that the family member is suitable for the job. Note, however, that wages paid to children and other relatives aren’t eligible for the Employee Retention Credit created by Congress in 2020 as part of the COVID-19 emergency relief measures for employers.
Rather than helping to support your children with your after-tax dollars, you can instead hire them in your business and pay them with tax-deductible dollars. Of course, the employment must be legitimate and the pay commensurate with the hours and the job worked. The following are typical situations encountered when hiring family members.
Employing a Child
A reasonable salary paid to a child reduces the self-employment income and tax of the parents (business owners) by shifting income to the child.
When a child under the age of 19 or a student under the age of 24 is claimed as a dependent of the parents, the child is generally subject to the kiddie tax rules if their investment income is upward of $2,200. Under these rules, the child’s investment income is taxed at the same rate as the parent’s top marginal rate using a lower $1,100 standard deduction. However, earned income (income from working) is taxed at the child’s marginal rate, and the earned income is reduced by the lesser of the earned income plus $350 or the regular standard deduction for the year, which is $12,400 for 2020. Assuming that a child has no other income, the child could be paid $12,400 and incur no income tax. If the child is paid more, the next $9,875 he or she earns is taxed at 10%.
Example: Let’s say you are in the 24% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $16,000 for the year. You reduce your income by $16,000, which saves you $3,840 of income tax (24% of $16,000), and your child has a taxable income of $3,600, $16,000 less $12,400 standard deduction, on which the tax is $360 (10% of $3,600).
If the business is unincorporated and the wages are paid to a child under age 18, he or she will not be subject to FICA – Social Security and Hospital Insurance (HI, aka Medicare) – taxes since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed in an unincorporated business owned by the parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes, and the business won’t have to pay its half of these payroll taxes either. In addition, by paying the child and thus reducing the business’s net income, the parent’s self-employment tax payable on net self-employment income is also reduced.
Use the same example from above. Assuming your business profits are $130,000, by paying your child $16,000, you not only reduce your self-employment income for income tax purposes, but you also reduce your self-employment tax (HI portion) by $429 (2.9% of $16,000 times the SE factor of 92.35%). And since your net profits for the year are less than the maximum SE income ($137,700 for 2020) that is subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion. So your total SE tax savings would be $2,261.
A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents. However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. Even so, there's no extra cost to your business if you're paying a child for work that you would pay someone else to do anyway.
Retirement Plan Savings
Additional savings are possible if the child is paid more (or works part-time past the summer) and deposits the extra earnings into a traditional IRA. For 2020, the child can make a tax-deductible contribution of up to $6,000 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child's age, and the number of hours worked. By combining the standard deduction $12,400) and the maximum deductible IRA contribution of $6,000 for 2020, a child could earn $18,400 of wages and pay no income tax.
However, referring back to our original example, the child’s tax to be saved by making a $6,000 traditional IRA contribution is only $360 (tax rate of 10% of $6,000 would be $600, but the savings is limited to the actual tax of $360). So, it might be appropriate to make a Roth IRA contribution instead, especially since the child has so many years before retirement and the future tax-free retirement benefits will far outweigh the current $360 savings. Of course, some children will not be thinking about retirement at their young age and may object to contributing to an IRA. If that is the case, perhaps you as the parent, or even the grandparents, can make a gift of the IRA contribution, which can grow to big bucks by the time the child reaches retirement age.
If you have questions about the information provided here and other possible tax benefits or issues related to hiring your child, please give this office a call.