How Hiring Your Children in the Family Business Can Save You Taxes
If you’re a business owner with children, you may be missing out on a valuable tax strategy – hiring your children to work in the family business. In addition to providing non-financial benefits such as spending more time together, hiring your children can provide significant tax savings in the right situations. Here’s what you need to know.
The Benefits of Hiring Your Children
The biggest and most obvious benefit to hiring your children in the family business is the ability to shift income from your higher income tax rates to your child’s presumably lower rates. Thanks to the Tax Cuts and Jobs Act, children are able to have more income than ever taxed at a 0% rate. In 2023, the standard deduction for individual filers – applicable to most minor children – is $13,850. This means minor children can earn up to $13,850 from employment and pay no federal income taxes. While state income taxes may apply to those amounts in certain situations, if the child is at a lower federal rate than their parents, they will also generally be at an equal or lower state income tax rate, too, making the potential income tax savings even greater.
No Kiddie Tax Worries
In situations where a business-owning parent is in a relatively high-income tax bracket, shifting income to the minor’s 0% federal and also-lower state tax rate can produce quite a bit of family tax savings – especially when there are multiple children to employ. And notably, the so-called “Kiddie Tax” is of minimal concern here, as the Kiddie Tax is a tax levied on “unearned income,” such as interest, dividends, capital gains, and distributions from inherited IRAs, 401(k)s, and other retirement accounts. In contrast, income generated from employment – including employment by a parent – is earned income. Thus, the Kiddie Tax does not apply to such amounts, and the full amount of the standard deduction (and availability of lower tax brackets) is permitted.
Qualified Business Income Deduction
For business owners at or near the new qualified business income (QBI) deduction phaseouts, the tax savings can be even more significant. For example, the payment of a salary to a minor can help reduce a parent-business-owner’s taxable income so they can enjoy a larger QBI deduction. In addition, the wages paid to a minor child count as wages paid for the wages or wages-and-depreciable-property tests for the QBI deduction. Which means those kids’ wages can slow down the phaseout of the QBI deduction for owners of Specified Service Trades or Businesses (SSTBs) with income within the phaseout range. It can also help to preserve up to the full QBI deduction for non-SSTB business owners with incomes within or above their applicable phaseout range.
Cumulatively, the reduction of the owner’s income via the payment of salary to a minor child, plus the potential increase in the owner’s QBI deduction as a result of such a decision, can save a business owner with the “right” set of facts and circumstances nearly 50 cents of every dollar paid to their child in federal taxes.
Example: Ryan’s Rakes
Let’s say Ryan owns a successful local rake store and is currently in the 35% tax bracket. Ryan has three children, ages 10, 12, and 17. If Ryan were to hire each of his children to work for the year and pay them each $13,850, the deductions would reduce his 2023 taxable income by $38,850 ($13,850 x 3 = $41,550), lowering his own taxes by $14,542.50 ($41,550 x 35% = $14,542.50). That tax savings alone more than pays for the salary of one of the children.
Valuable Experience
Additionally, hiring children in the family business can provide benefits for the business itself. Children who work in the family business can gain valuable experience and develop important skills that they can use later in life. Furthermore, they may be more invested in the business and its success because they have a personal stake in it.
There are a few factors to consider before hiring your child in the family business. First, you should make sure that the child is actually performing work for the business and that the compensation is reasonable. This means that you should have a clear job description, record hours worked, and pay the child a fair wage based on their work. You should also be aware of any child labor laws in your state that may restrict the amount of hours or types of work that a minor can do.
However, it's important to note that the child must actually be performing work for the business in order to qualify for these tax benefits. If the IRS determines that the child is not doing real work or that the compensation is not reasonable, they may disallow the tax deductions. It's also important to keep in mind that state income taxes may still apply to the child's income.
There are a few other potential drawbacks to hiring your child in the family business. One is that it may affect their eligibility for financial aid for college. If the child earns a significant amount of money from the business, it may be counted as income on the Free Application for Federal Student Aid (FAFSA) and reduce their eligibility for need-based aid.
Bonus! Funding Roth IRA
Because your child will be earning income, they will be eligible to open and fund a Roth IRA. This potentially means tax-free income going into an investment vehicle that produces tax-free growth and distributions. This is a superpowered estate planning technique so you won’t have to worry about leaving anything to your children because they will already have plenty of assets if they fund it with enough assets.
Bonus! Part 2 Employee Benefits
Your child will be eligible for employee benefits such as HSAs, FSAs, or retirement plans such as a SEP IRA. Take into consideration that you might have to adjust the access rules into the plans and that there will be added costs that may outweigh the tax savings.
Here is a quick list of considerations when determining if you can hire your child:
Is the nature of the work allowable by the federal and your state government?
Will you pay a reasonable wage for the work performed?
Are there any federal or state limitations on the amount of hours they can work?
Are you, and possibly your spouse, the only owners of the company? If anyone else is an owner, the company is ineligible for the tax benefit.
Is the business a sole proprietorship, single-member LLC, or partnership? These avoid social security and Medicare taxes paid by child.
Will you owe state taxes? Such as unemployment.
Can you qualify for Qualified Business Income deduction?
Are you willing to open a family management company to use this strategy?
Are you hiring them for a real job?
Can you keep accurate records? Necessary in the case of an audit.
Is financial aid a concern for education funding?
Will you be able to maintain the child as a dependent? You must provide more than half of their support to claim your child as a dependent.
In conclusion, hiring your child in the family business can be a smart financial move, but it requires careful planning and consideration. By ensuring that your child is performing real work and receiving reasonable compensation, you can take advantage of tax benefits and provide valuable experience for your child. However, it's important to be aware of potential drawbacks, such as impacts on financial aid and Social Security benefits. With the right approach, hiring your child in the family business can be a win-win situation for everyone involved.
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