Ahhh, summer jobs! Seen as a rite of passage, summer jobs can instill many values: punctuality, work ethic, teamwork, leadership. Summer jobs can even lead to all year around jobs, and when done so through a family business, the benefits can be even greater as it allows children to learn about their parents’ business. The neat thing is that there can even be some financial benefits to such an arrangement. While there are some tax benefits, the entity type can enhance the tax benefits of employing your child. This post will discuss some of those tax benefits and some other considerations to properly reap the tax rewards.
How the tax benefit works
As many of you know, wages paid to employees are a business tax deduction. Business tax deductions decrease the amount of profit. The disadvantage of limiting your profit is obvious. Less money in your pocket as a business owner. The advantage of limiting your profit as the owner of a pass through business (S Corporation, partnership, sole proprietorship, some LLCs) is less taxes. Legitimately employing your child is a way to reduce your family’s overall tax burden by reducing your profit while keeping money in your family’s pocket. The business would get the tax deduction which would reduce your taxable income at a presumably higher rate than your child, but your child would have to pay taxes on his or her wages. Luckily, though, your child may end up paying very little in taxes on their wages.
Standard Deduction
The standard deduction for a dependent is the greater of $1,100 or the dependent’s earned income plus $350 not to exceed the basic standard deduction for the dependent’s filing status. This essentially equates to the first $12,400 of earned income being offset by the standard deduction.
IRA contribution
One of the requirements of being able to make an IRA contribution is that the taxpayer must have earned income. Now that your child has earned income from their employment they can contribute to an IRA. Individual retirement accounts can be used a couple of different ways for the benefit of a child. Most children are not thinking about retirement, but contributing to an IRA early could be that much less they’ll have to save in their later years. Another benefit is that a Traditional IRA contribution would be a tax deduction which could help your family shield even more money from income taxes today. Lastly, if the child decides to contribute to a ROTH IRA, they would be able to access their contributions any time tax and penalty free. Some children use these contributions for major expenses such as tuition, wedding, or house down payment. On a side note, the child having an asset like an IRA could potentially impact financial aid so you’ll want to consult your financial advisor.
Maintaining contemporaneous records
Employing your children comes with some caution. You’ll want to review labor laws to ensure you are not running afoul of any of them. You’ll also want to hire them to do real work. You cannot just put them on payroll without having them actually perform services. You may also want to consider keeping logs of their work and hours. Additionally, do not overpay them. You should pay them a reasonable wage. For example, do not pay them $20 per hour when you would typically pay a non family member minimum wage.
Payroll
A child employee under the age of 18 is not subject to payroll taxes if their parent’s business is a sole proprietor or partnership which each parent is a partner. A child under the age of 21 is not subject to FUTA tax if they work for their parent’s trade or business, but they may still be subject to state unemployment taxes. The child’s wages are subject to payroll taxes if the employing company is a corporation.
Example
Bill had $200,000 of qualified business income from his S Corporation last year, and he was in the 32% tax bracket because of other wages and rental income. Bill is expecting his income to be the same this year. His daughter turned 16 at the end of last year and now has a driver’s license, so Bill decides to offer her a part time job. She accepted and worked enough hours to earn $10,000 in compensation. Her wages reduced Bill’s amount of qualified business income to $190,000 and reduced his taxes by $3,200 ($10,000 multiplied by his marginal rate of 32%). Meanwhile, Bill’s daughter paid no federal income taxes because her income was less than the standard deduction amount.
Employing your children can lead to benefits for the entire family and not just tax and financial benefits. Who knows? Maybe you’ll even find your future succession plan.
Disclosures
This material was created for educational and informational purposes only and is not intended as tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.