Kids on the Payroll – A Tax Savings Strategy

Business owners may be able to reap significant tax savings by hiring their children/grandchildren and putting them “on the payroll.” This tax savings strategy must involve paying “real wages for real work,” and the amounts paid to your kids must be “fair and reasonable.” You should also consult with your tax advisor about how this strategy could work for you with your specific fact pattern.

SHIFTING INCOME FROM YOUR TAX BRACKET TO YOUR KIDS’ TAX BRACKETS

As most of us know, the more income you earn, the higher your Federal income tax bracket goes—-up to 37% this year, and that does not include state/local income taxes. A child (or for that matter, anybody) can earn up to $14,600 in 2024 in “earned income” (wages) and pay zero Federal income tax since that is the amount of the “standard deduction” in 2024—nobody pays Federal income tax on the first $14,600 of income earned during 2024. If a child earns in excess of $14,600 in 2024, they would only pay about 12% federal income tax on the excess earned over $14,600. SO, if a small business owner is in the 25% federal income tax bracket and pays a kid a “fair salary” based on the value of services rendered of $10,000, the parent saves $2,500 in Federal income tax for the deductible wage expense and the “kid” pays zero Federal income tax.

MOST OF THE BENEFITS FROM HIRING A CHILD/GRANDCHILD ARE BASED ON SHIFTING INCOME FROM A PARENT’S FEDERAL INCOME TAX BRACKET TO THE KID’S LOWER/ZERO TAX BRACKET.

WHAT ABOUT FICA AND OTHER PAYROLL TAXES?

If you operate your business as a sole proprietor, single member LLC or family partnership, with no owners other than parents (generally filing of a Schedule C on your Form 1040), then payment of wages to your own children are exempt from FICA tax until they turn age 18 and FUTA exempt until they turn age 21. With this ownership, your FICA/Medicare tax savings will generally be about 15% of the wage amount—-so another $1,500 of tax savings on $10,000 of wages paid to a child under 18.

HOWEVER, if you operate your business as a corporation (to include LLC’s taxed as corporations), OR you are in partnership with a non-parent of your child, payment of wages to your child IS subject to FICA/Medicare tax withholdings and employer matching funds (approx 15% rate). I might add that shifting your business type from a corporation to a single member LLC/Schedule C simply for the child payroll tax savings could involve more costs than the child payroll taxes—-AND paying your kids from a S corporation will still save Federal income taxes, but likely not FICA/payroll taxes

WHAT WILL YOUR KIDS/GRANDKIDS DO WITH THEIR WAGES?

Many parents who put their kids “on the payroll” will simply save the wages for college or some other major purpose. It is not uncommon that the child contribute their wages to a Roth IRA, up to the lower of their “wage amount” or the maximum permitted annual Roth contribution of $7,000 (2024 amount). The Roth account will grow tax-free over the years for either retirement OR it can be withdrawn tax-free for “qualified educational expenses.” (college tuition, room/board, books, etc). However, a comparison of funding a Roth IRA for education to a tax-favored 529 plan should be made before choosing the best college funding “tax tool”—See our previous PayDay about 529 plan benefits.

It is also possible to use the child’s wages for “discretionary” spending such as summer camps, athletic costs, piano lessons and the like—costs other than “necessities” which parents need to fund to claim the child as a dependent/child tax credit!

HOW MUCH SHOULD I PAY MY KIDS/GRANDKIDS?

The IRS indicates that you should pay your kids a “reasonable wage amount” which is consistent with the value of the duties performed. If I were not putting this in writing, I would say, “reasonable but on the high side” (I guess I just wrote it!!). I do believe that a child in a family business has some “business dna” about how things should be done, which has some added value over other non-family members in some cases. A Job Description of tasks to be performed to document the child’s work is also recommended in the event of an IRS audit.

WHAT ABOUT CHILD LABOR LAWS?

A child who works directly for their parents (NOT through a corporation) is generally exempt from child labor laws.  A child who works for a corporation is not exempt from child labor laws if they are under age 14. You may wish to check with your own state’s child labor laws for details about hiring your children, since each state has their own unique labor laws, and as a general rule, an employer must abide by the more stringent labor laws between DOL and their home state.

FAMILY MANAGEMENT COMPANIES IF YOU OPERATE AS A CORPORATION AND WISH TO PAY YOUR CHILDREN/GRANDKIDS

A rather creative tax/legal strategy used by some tax planners is to setup a “family management company” (FMC) as a “single member LLC” or even a sole proprietorship and to pay their kid(s) from the FMC. This involves the business corporation contracting to pay management fees to the FMC for services rendered by the parent (who is NOT on the payroll of the FMC) and their kids. The FMC would need to register as an “employer” and pay wages to the “kids” who are working for the FMC. If done correctly, the management fees paid by the family corporation to the FMC are business deductions (if fair as to amount) and are “income” to the FMC. The kids are paid “fair wages” from the FMC since they are working for the FMC—as a general rule, the profit remaining after payment of kids’ wages is not significant.

BENEFITS OF A FMC

1. Since the FMC is an employer entirely owned by the parent(s), wages paid to kids are exempt from FICA taxes until the child hits age 18; and
2. Children employed by just their parents, not a corporation, are not restricted by child labor laws under any age

DISADVANTAGES OF THE FMC

More administration to pay children as young as “toddlers” as well as processing payroll/payroll tax returns. The parents must file a tax Schedule C with their Form 1040 but also must write payroll checks to their children and file payroll tax returns to document the family payroll as “legit,” as well as the kids actually doing “work for fair pay.”—-Unless you withhold state/local income taxes from your kids gross wages, their gross wage and net paycheck amounts would be the same, meaning that filing quarterly payroll tax returns/941’s or 944’s should be simple—the kids can likely pay their state/local income taxes directly with their personal income tax returns.

 PRACTICAL COMMENT—-Forming a family management company (FMC) is generally considered only if multiple children are involved and/or the kids’ wage amounts are “on the high side”—-but FMC’s are used by some if they wish to compensate very young kids, such as “kid models” for your family logo/family business (child dentist, daycare, etc)

IF YOU DO CONSIDER A FMC, CONSULT YOUR TAX ADVISOR FIRST!!

IN CONCLUSION

Adding owners’ children/grandchildren to the payroll can have some significant tax benefits. Be sure to check with your tax advisor to ensure your business qualifies and that the strategies you employ are in line with IRS guidelines. AccuPay has discovered an excellent resource, developed by Jamie Trull, CPA, providing business owners with a long list of suggested “jobs” that children can do for your business.

Ready to add your child(ren) to the payroll? Be sure to contact your Payroll Specialist at payroll@accupay.com or 317-885-7600 to ensure taxes are set up correctly to maximize your savings!