Update: Tax consequences of putting your child on the payroll

Update posted on July 15 2009 Back to Blog

With summer vacation finally here, you may be considering hiring your children to work in your business. Whether you run a restaurant, shop or office, hiring your children has certain tax implications. Putting your child on your payroll is a smart move that can save you money in taxes…and get your child involved in the family business!

Deductible business expense

The wages you pay your child are tax deductible on your income tax return (or that of your business) as business expenses. As a general rule, a business can claim a tax deduction for the salary, wages, commissions, bonuses, and other compensation it pays to its employees. Don’t forget a W-2 for your child at the end of the year, either.

How much is too much?

If you are putting your child on the payroll, be careful how much you pay him or her in wages since the IRS requires that your child be paid a reasonable amount for the labor provided. Generally, the IRS does not challenge the amount of compensation as unreasonable unless, among other things, the employee has a personal relationship with the employer. Translation: If your daughter is bussing tables and sweeping floors, paying her $25 per hour will likely be deemed “excessive” by the IRS. The IRS in these cases is not only concerned about “no show” jobs but also those paid at an unreasonable salary level. Proof, in the form of time logs and comparable salary levels in the industry, will go a long way in helping keep the deduction should the IRS audit this aspect of your business.

Standard deduction

Due to the standard deduction for 2009, the first $5,700 of your child’s wages would not be taxed. Your child, however, cannot take a personal exemption deduction if you are claiming her as a dependent also. For example, if you file a Schedule C, Profit or Loss from Business, the $5,700 you pay your child, which is non-taxable to her, reduces your Schedule C income by that amount. If you are in the 35percent tax bracket, the deduction will save you $1,881 in federal income taxes and at no tax cost to your child.

Comment. The actual computation of a child’s standard deduction includes limitations so investment income cannot be unnecessarily sheltered by a child. For tax years beginning in 2009, the standard deduction for a dependent may not exceed the greater of $950, or the sum of $300 and the dependent’s earned income (up to the regular standard deduction amount). The threshold for the application of the kiddie tax is twice the amount of the limited standard deduction for a dependent, or $1,900. Earned income is not subject to the kiddie tax.

Limited withholding responsibilities for Social Security and Medicare taxes

The wages you pay your child (as long as they are under the age of 18) may not be subject to Social Security, Medicare taxes, or state disability/unemployment taxes. This exemption is specifically provided for in the Internal Revenue Code. “Employment” for purposes of Social Security and Medicare taxes (FICA) generally excludes services performed by a child under the age of 18 in the employ of his or her parent if the parent’s trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child.
However, the wages you pay your child for services are subject to income tax withholding, as well as Social Security, Medicare, and FUTA taxes if your business is:

• A corporation, even if it is controlled by you or your spouse;
• A partnership, unless each parent is a partner;
• A partnership, even if the child’s spouse is a partner;
• An estate, even if it is the estate of a deceased parent.

Moreover, children under the age of 21 are exempt from Federal Unemployment Tax (FUTA), whether or not in a trade or business. But remember, you still will need to withhold federal income tax and file a W-2 form for each of your children you employ.

IRA contribution
You may be able to shelter an additional 15 percent of wages (up to $5,000) by contributing to an IRA for your child. A contribution to a regular IRA is deducted from income. This strategy works even better with a Roth IRA. Although contributions to a Roth IRA are not deductible, the wage income allows your child to make contributions. Those amounts grow tax-free as long as your child keeps the account.

What about the “kiddie tax”?

If you are worried about the effect of the dreaded “kiddie tax,” relax. The “kiddie tax” does not apply to your child’s “earned” income – which is any income your child earns from working, as opposed to “unearned” investment-type income. Therefore, your child’s earned income from working for you will not be taxed at your top marginal tax rate.

Putting your children on the payroll can be an effective way to reduce your tax liability and increase your family’s net worth. For more information about how you and your family can benefit from this tax saving idea, contact AHP.

IRS Circular 230 Disclosure - As required by IRS rules, although this written communication may address certain tax issues, the issuer of this document did not intend nor write the advice to be used to avoid any penalty imposed by a taxing authority, nor may the user/recipient of this document use this document’s written tax advice for that purpose. Nor may it be used to promote, market or recommend to another party any transaction or matter addressed herein.