Should you hire your children to work in your business?
I want you to stop for a moment and imagine shifting some of your taxable income to a zero tax bracket. That’s right, a zero tax bracket, and it’s perfectly legal — if you do it right.
Read on to learn how to make some of your business income taxable at the very attractive tax rate of ZERO!
One way to reduce your tax is to hire your children to work in your business, shifting income to a zero bracket or lower bracket than yours. You can also maximize this benefit with retired parents. The IRS code allows family members to perform bona-fide services, which must be provided and documented, for reasonable compensation.
Let’s assume that your business is a legitimate business. Now don’t go getting all upset. In my twenty plus years in public practice as a CPA, I have seen some strange things. When using the term legitimate business, first let me explain what the IRS defines as a business.
According to the IRS’s definition of a business, “In general, the Internal Revenue Service (IRS) considers an activity a business if it is carried on with the reasonable expectation of earning a profit. One way the IRS determines if your side activity is a business is whether you were able to show a profit in three of the last five years.”
So, even if you have just started up and may not have made a profit yet. That’s OK. Your activity would still be considered a legitimate business if you have the intent, or reasonable expectation, of making a profit.
I am clarifying this because people can often make the mistake of thinking that their business is legitimate, when on paper, it is not considered a business. What I really don’t want to have happen is for you to think you can put your kids on the payroll for the purposes of creating tax losses in your business. If you don’t show a profit in three of the last five years, the IRS is likely to reclassify your business as a hobby and disallow all your business deductions.
Let’s further assume your business is making a profit and you know what type of entity your business is. By that I mean that you know exactly what type of corporation your business would be classified under. Is your business filing as a Sole Proprietorship on a Schedule C? Or is your business organized as a Partnership or an S Corporation? It is important to know what type of business you’re operating because the rules are different for different entity types.
It is vitally important that you understand that if you plan to deduct the service your child or children provide in your business, they must actually perform said services AND you must actually pay them for these services at a reasonable rate. The compensation you pay them must be paid to them in the form of cash money, not pizza. While this may sound obvious, it may not be to everyone… There was a great article a few years back in the Wall Street Journal about a woman who got herself in trouble with the IRS because she was paying her three kids in pizza. The IRS disallowed all that labor expenses because she didn’t actually pay them any money.
To further the legitimacy of the deduction, the checks should be deposited into a bank account in the child’s name. The time they spend performing these services should be tracked on a time card, just like any other employee. Additionally, the rate you pay them should be reasonable based on what any other employee would make for the same type of services.
As with everything the IRS does, there are rules you have to follow. If you don’t do it right and follow the IRS’s procedures, you could get audited and the IRS may disallow your deductions and may even charge you a penalty for disregarding the rules.
If you are a sole proprietor filing on a Schedule C, a business that is organized as Single Member LLC, or if you and your spouse have a partnership together you can employ your children and avoid payroll taxes on those wages.
If your business is an S Corporation, you will need to pay payroll taxes (Social Security and Medicare) but can avoid unemployment taxes, federal, and in some cased state unemployment taxes too. If your business is a C corporation, in most cases the S Corp rules will also apply.
In almost all cases you will want to provide your employed child/children with a W2 form. However, if the wages are less than or equal to the standard deduction, ($12,400 for 2021) then they won’t even have to file a tax return. We recommend you don’t withhold any federal tax or state tax, so you don’t have to file a tax return to get a refund back of the taxes that were paid in.
But think it through. If your kids have earned income, a.k.a. wages, they can now contribute to a Roth IRA (up to the limits allowed) and begin building a source of tax-free retirement income for the future. So, this money is tax free today, AND tax-free down the road.
CONTACT US today to schedule a free tax assessment with our experienced tax planners. The sooner you do it, the more we can save you this year.