Paying your children properly is an excellent strategy to minimize their tax liability and create other ancillary benefits. However, if it is not processed properly on the ‘books’ and ‘tax return’, it can be an audit risk.
Here is what that IRS says:
• Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes (FICA) 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 parent in a trade or business are not subject to Federal Unemployment Tax Act (FUTA) tax.
• Payment for the services of a child is subject to income tax withholding, regardless of age.
Note, however, because of the standard deduction for 2021, the first $12,550 ($12,950 for 2022) your child makes is entirely exempt from income taxes. How does that work?
The standard deduction that the IRS gives taxpayers reduces taxable income dollar-for-dollar up to $12,550 for those filing single. Be mindful of your state’s standard deduction and personal exemptions, where applicable. There are some states that do not follow Federal and have lower standard deductions and/or no personal exemption, which may cause the child to pay state income taxes.
• The wages for the services of a child are subject to income tax withholding as well as social security, Medicare, and FUTA taxes if he or she works for:
o A corporation (including S-corporations), even if it is controlled by the child's parent,
o A partnership where one of the child's parents is a partner, the exception is if each partner is a parent of the child, or
o An estate, even if it is the estate of a deceased parent.
So, what does this mean?
You can shelter yourself from paying most—if not all—taxes on the wages you’re paying your children if your business is either:
• a sole proprietorship,
• a partnership where both partners are spouses, or
You can deduct their salaries as a business expense, thereby, reducing your business’ taxable income. How do you do this WITHOUT getting in trouble?
The IRS knows there is a huge benefit in doing this, so they often look more carefully. Follow the guidelines as noted above, but here are some tips to keep you on the straight and narrow.
• Your child must be an actual employee doing necessary work for your business. Do not just add their name to payroll and to pay them for the use of their name. Paying them for doing their chores will not cut it either. They must be doing ACTUAL work FOR your business.
• According to most state requirements, your child must be seven or older to be considered a valuable employee.
• The salary you pay your child must considered “reasonable” for what you have them doing for the business. Stuffing two envelops for the week and cutting them a check for $1500 will not do. • You must follow all the legal rules of employment for Federal and State purposes. Do the same process with your child as you would with any other employee.
o Fill out Form W-4 and the Employment Eligibility Verification (Form I-9)
o Make sure you have an Employer Identification Number and state withholding ID o If you plan to have your child contribute to a Roth IRA, file Form W-2 at the end of the year, reporting how much you paid them. Otherwise, a Form W-2 is not required since there is no withholding to report. However, for audit trail and IRS matching purposes, we recommend that you include your child as part of the Form W-2 filings.
o Have them complete timesheets
If your business is a C-corporation or S-corporation, as a workaround, you can set up a separate sole proprietorship, owned solely by you or by you and your spouse, to support the operations of your main c corporation or s-corporation. For example, the sole proprietorship can handle the administrative functions of the c-corporation or s-corporation. The C-corporation or S-corporation pays the sole proprietorship a management fee for administrative support, per a management agreement, and the sole proprietorship pays your child directly, not the C-corporation or S-corporation. In the event of an audit, you’ll have to show that the sole proprietorship is legit and doing work for the C-corporation or S-corporation. Documentation matters! Keep track of all employee’s time worked and what they did.
Upon hiring your child, open an individual retirement account (IRA) for them. For 2021 and 2022, the maximum your child can contribute to an IRA (either traditional or Roth) is the lesser of $6,000 or their taxable earnings for the year. In general, the Roth IRA is the IRA of choice for minors who have limited income now—as it's recommended for those likely to be in a higher tax bracket in the future.
Children of any age can contribute to an IRA as long as they have earned income from a job or their business of their own. Money from an allowance or investing income does not count as earned income and, therefore, cannot be used towards contributions. Typically, your child should receive a W-2 or Form 1099 for work performed. But this may not be the case for jobs like babysitting, yard work, dog-walking, and other common juvenile jobs, so have your child develop a tracking system to document the type of work performed, their schedule, their clients, and how much they earned from each job.
Direct contributions to a child’s Roth IRA can be a gift from you or someone else. The IRS doesn’t care who makes the contribution as long as it does not exceed your child’s earned income for the year. However, keep in mind that the contributions you make to a Roth IRA for your kid will count against the limit on tax-free gifts you can make to one person, which is $15,000 for 2021 and $16,000 for 2022. Since the contribution is made to your child’s IRA, your child—not you—receives the tax deduction or future tax benefit.