I am often asked by business clients, “Is there any benefit to hiring my children in my business?” The answer is, “Absolutely yes!!!!”
Hiring children in a family business often provides valuable work experience to children. Many business owners would love to transfer a successful family business to the next generation. Starting early allows the children “get their feet wet.” The business owner can also assess whether the child has the ability and the desire to succeed.
But more than that, there are substantial tax benefits to hiring your children in a family business:
- The business gets a tax deduction for the wages paid. Typically, the parents are in a higher tax bracket than the children.
- Children that make under the standard deduction often pay no federal income taxes on their wages.
- Wages are considered “earned income.” The child can make a Roth IRA contribution that can grow tax-free until his or her retirement years.
- Payments for the services of a child under age 18 who works for his or her parents in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child.
- Payments for the services of a child under age 21 who works for his or her parents in a trade or business are not subject to Federal Unemployment Tax Act (FUTA) tax.
Kathy owns a bakery and employs her 16-year-old son Franklin and her 19-year-old daughter Bren to work in the business. Since he is under 18, Franklin is an excluded family employee and his wages are not subject to social security tax, Medicare tax, or Federal unemployment tax (FUTA). If Kathy is a California employer, Franklin’s wages are also not subject to California State Disability Insurance (SDI), State Unemployment Insurance (SUI) or Employment Training Tax (ETT).
Since Bren is over 18, her wages are subject to social security tax, Medicare tax and California payroll taxes. However, her wages are not subject to FUTA tax.
Both Franklin’s and Bren’s wages are subject to personal income tax if they make more than the standard deduction.
Protect your tax deduction! It is very important for family businesses to do the following when paying family members wages:
- The wages should be reasonable in relation to the services provided by the child. A 16-year-old could reasonably provide administrative services, but a 4-year-old probably could not.
- Time reports, time cards or descriptions of times and work performed by the child are important. There have been a number of tax court cases where wages paid to family members have been challenged. Better documentation by the taxpayer provides support for the tax deduction.
- Applicable labor laws, including overtime and minimum wage laws, must be followed.
- Workers’ compensation insurance is sometimes required. Check with your workers’ compensation provider.
Employing family members can be a great opportunity for tax savings. The prospect of passing on a family business and allowing the founder to step back and see the business continue brings its own rewards. Be sure to check with your tax advisor for details in your state.
© Daniel J. Domancich, CPA, CFP®