Thinking about hiring your children as a tax loophole? Probably because it’s summer, several clients and friends have recently asked me about this.
And the question is good one. This gambit often makes for great tax savings. You can save thousands in taxes. Per kid.
But you may find this deduction tricky to take. Accordingly, let me explain why you save money, how you can save even more money by doing this right, and then point out where and how people can get tripped up if they’re not careful.
Kids and Grandkids as Income Tax Loopholes
Employing your children usually saves quite a bit of income tax for a simple reason.
You may pay a pretty high tax rate on your last dollars of income. For example, you might pay 25% or 28% in federal taxes and probably a very noticeable state income tax, too.
If you’ve got a really successful business, given the progressive nature of income taxes, you might pay even higher marginal rates on your last dollars of income. Federal income tax rates go as high as basically 40%.
In comparison, if you hire your son or daughter (or even your grandson or granddaughter) and you do the accounting right, they will pay no federal income taxes on the first $6,200 they make. They will probably pay very little state income tax. And even if they make more, the federal and state tax rates will be low. A child or grandchild might make as much as $20,000 a year and pay an average tax rate of less than 10%, for example. And that tax bill might be easily ground down to nearly zero if the child or grandchild qualifies for tax credits the business owner can’t use.
In short, paying a generous wage to a family member can save a business owner substantial taxes.
Example: You pay your son or daughter $5,000 on which you would have paid a combined 30% federal and state income tax. Your son or daughter will pay no income taxes. Zero. In this case, you reduce your income tax bill by $1,500.
Minor Children as Payroll Tax Loopholes
If you operate as a sole proprietor or you and your spouse operate a partnership and you employ your own minor children, you may be able to save even more tax.
Here’s why: You won’t need to pay, and the kids won’t need to pay, Social Security, Medicare or FUTA taxes on their wages if the kids are minors.
I’m going to ignore the FUTA tax because it’s tough to generalize about that. (The actual tax rate you pay for FUTA depends on whether or not your business pays state unemployment taxes.)
But to focus on just the Social Security and Medicare taxes, those add up to 15.3% of the wages paid if you combine both the employer and employee shares.
If you have $5,000 of income on which you as proprietor would pay a 15.3% tax, that adds up to $765 of taxes. If you pay that $5,000 to your son or daughter instead, you therefore save the $765 that you would have had to pay had the income been counted as yours.
Let me add up the savings we’ve identified, okay? In some cases, by paying a son or daughter $5,000 in wages, you may be saving more than $2,000 in taxes. Maybe $1,500 in income taxes. Maybe another $765 in Social Security and Medicare taxes. Yikes. It adds up quick, right?
Note: The Internal Revenue Service website has a page with a nice write-up on how the payroll tax accounting works with family employees. Click here if you’re interested.
But You Need to Be Reasonable
Obviously, the gambit of employing your kids, and even your grandkids, can be a real tax saver. But let me issue a handful of comments and caveats.
Here’s my first caution: You have to be reasonable in all this. In other words, the amount you pay your child or grandchildren or whatever needs to be reasonable.
Just to make this point, you writing the check doesn’t automatically create a deduction. The deduction only works if you’re paying someone a reasonable wage given the job they’re doing for your business.
I’m going to quote here from the relevant Treasury Regulation just because that seems like a good idea. Note that you can skim the quoted material and focus just on the parts I boldfaced and italicized—the highlighted material is what you want to internalize:
§ 1.162-7 Compensation for personal services.
(a) There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.
(b) The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows:
(1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock. An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business.
You get the point. The job you provide your son or daughter needs to be a real job.
You Want to Be Diligent about Documentation and Bookkeeping
A related caution: If you are examined by a federal or state auditor, the auditor will naturally expect you to convince them of the reasonableness of your employment arrangement.
Accordingly, you want your recordkeeping and payroll tax accounting to all tell the same story. Make sure you’ve got any state permits necessary to employ children, for example. Do the payroll for your kids the same way another employer would do payroll for a non-family-member employee. (Maybe you want to use timeslips?) Pay an obviously fair market rate.
Note: Probably paying $15-an-hour, even for a teenager, works pretty well in any community that is rolling out or discussing actively the $15-an-hour minimum wage law.
Make Sure You Aren’t Losing Money
A quick comment that’s sort of off-topic but still super economically relevant: You will reduce taxes by employing a child in most situations. No argument there.
But if your new employee isn’t doing a real job that you need someone to do, you’re not necessarily saving money.
What would be a better deal, probably, would be if your son or daughter worked for some other business owner—somebody other than Mom or Dad—and did real work earning a real wage for this other employer. (This approach might also be a good step toward independence and developing good work habits.)
This makes sense, right? You don’t really make money if you pay Biff (your son) or Buffy (your daughter) $5,000 so you can save $2,000 in taxes. You actually lose $3,000 in this case (unless you make the kids pay the $3,000 back to you in some way—which really means the money was never really their wages.)
Working the Working Condition Fringe Benefit Angle
Let me give you something else to think about, too.
While the payroll tax and income tax savings angles are often what business owners focus on, some business owners may have another truly powerful tax planning angle they can employ.
I can’t describe this option here in detail—we don’t have space—but let me give you a quick overview. If your son or daughter works in your business and the business pays for training that lets them do their job better but also training that doesn’t prepare them for a new profession, you may be able to deduct those training costs as a “working condition” fringe benefit.
Let me give you some examples that show how this might work—and also when this won’t work.
Example #1: You run the construction firm your father started. Your son or daughter, who already works in the business, will someday take the reins from you and run the business. In this case, you can probably deduct most and maybe (depending on the program) all of the tuition costs for a degree in construction management or business administration. The tuition is deductible, by the way, because it lets you son or daughter do their current job better—not because it prepares them for the role of someday running the construction company.
Example #2: You run a small law firm in which your son or daughter works as an office manager or legal assistant. In order to do their job better, you pay for a college degree in business administration or some pre-law degree or some technical program in being a legal assistant. In this case, you may be able to deduct most and again maybe even all of the tuition costs for the degree if the training helps your son or daughter do their existing job better, but doesn’t prepare them for a new profession.
Example #3: Let me now give you an example of when this deduction clearly does not work. Suppose you run a small law firm in which you son or daughter works. Further, suppose you pay for your son or daughter to attend law school—you know, so they can do their job better and someday take over the family law firm. Can you deduct the costs of law school? No. This course of study prepares your son or daughter for a new profession, being a lawyer. Therefore, the expense doesn’t qualify as a working condition fringe benefit.
Summing Up the Hiring-Your-Children-as-a-Tax-Loophole Gambit
A couple of final comments: First, lots of small business owners probably should consider hiring their children. The move may make great sense not only for tax savings reasons but also for long-term strategic reasons.
Second, if you decide to do this, you need to do your accounting cleanly and make sure the arrangement clearly makes business and economic sense. If you don’t do the accounting right or you don’t create a real job, sorry, you won’t sustain your tax savings if the IRS or equivalent state revenue agency challenges you.
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