The 12 Tax Days of Christmas: Day 5
Rather than your true love sending you a partridge in a pear tree, wouldn’t you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I’ll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For this fifth tax day of Christmas, it's time to talk about putting your kids on payroll. This is an absolutely critical year-end strategy and one of the most under-utilized. You can’t just say you paid your kids; you actually have to follow through with the process and a paper trail. Regrettably, many entrepreneurs don’t realize that paying their adult children, as well as children under age 18, is a legitimate and common strategy that saves taxes and generates a host of other ancillary benefits.
Paying Children Under Age 18
It’s important you follow the right procedure when paying your kids who are under 18, or this strategy could backfire on you. Here are the pertinent facts and rules to follow when putting your minor children to work in the business....
First, you don’t have to withhold any income taxes or payroll taxes. This also applies to state and federal unemployment insurance. The reasoning is that your children are unlikely to file for unemployment insurance, since they are dependents and you are providing for their care. Again, this is only for children under 18. Still, I recommend you review the laws in your jurisdiction to ensure you are operating legally regarding workers comp and other payroll taxes, as well as work permits and other regulations.
Second, all of us, including our children, don’t pay taxes on the first $12,200 we earned in 2019. It’s the standard deduction, which is adjusted for inflation each year. Interestingly, you can still claim your children as dependents on your tax return and take the child tax credit if you qualify. However, they don’t pay taxes on their earned income up to the standard deduction. Stated another way, your children get their own standard deduction for their earned income even if they are a dependent of yours on your tax return.
Therefore, when you pay your children for services they perform in your business, you can generate an expense for your income taxes by pushing income to your children. Of course, I’m not advocating you pay your children as a sham operation. They must be legitimately involved in the business; you will want to keep records of their time worked, as well as pay them a reasonable wage. This could include having a clear job title and description for the child and keeping track of their tasks.
Related: The 12 Tax Days of Christmas: Day 3
Use the Correct Entity to Pay Them
It’s important to avoid issuing a W-2 to your children under age 18. It’s not required by the IRS and will cost you in unnecessary FICA taxes. The IRS allows any sole prop or partnership (LLC) that is wholly owned by a child’s parents to pay wages to children under 18 without having to withhold payroll taxes.
However, if you have an S- or C-corp, you need to follow a different procedure. You do not receive the benefit of avoiding FICA when paying your children, unless you pay them through a sole prop or an LLC owned solely by mom and dad. Bottom line: Don’t pay your children out of a corporation or you will have to withhold payroll taxes. Thus, we recommend you pay children out of a family management company, structured as a sole prop or LLC with independent income and operations, and pay it a management fee from the corporation.
Paying Children 18 and Over
If you are paying children 18 or older, you have the option of treating them as subcontractors or as employees. If you pay them as a subcontractor, then you simply issue them a 1099 in January. They file a small-business Schedule C, get to take small-business tax deductions, take a standard deduction of $12,200 in 2019 (adjusted for inflation each year) and will probably be in a lower tax bracket than you. If done properly, the savings you get as a family can be phenomenal. I love to see older children serving on the Board of Directors in a corporation or Board of Advisors in an LLC, providing advisory services, marketing support, research, consulting, etc.
However, if your adult child works in your business alongside your other employees and looks like and acts like an employee, then you need to treat them as an employee. Thus, you will have to withhold FICA and other typical payroll fees. Again, with overall family tax planning, there is nothing wrong with this. A little tax strategy with your kids can go a long way.
Legitimate Work and Services
Now comes the strategy. Where do the kids get earned income? As mentioned earlier, I’m not advocating you pay your children illegitimately. Hiring them simply to execute "family chores" is not going to qualify as a valid deduction and will certainly set you up for an audit.
Make sure you keep a record of the services they provide and hours worked. However, with older children, this could be as simple as serving on the Board of Directors or Advisors and helping as a contractor on projects throughout the year. Be creative, but honest and legitimate.
Related: The 12 Tax Days of Christmas: Day 4
Ancillary Benefits of Hiring Your Children
You can still claim your children on your tax return as a dependent and even tax the child tax credit. However, they don’t pay taxes on their earned income on the first $12,200. Thus, you generate an excellent tax-deductible expense for your income taxes (inside your business) by pushing income to your children.
Getting your family involved in the business has so many different benefits besides saving taxes. I have seen this strategy not only save clients thousands of dollars in taxes, but literally change the lives of their families. Children begin to learn work ethic, and it can draw a family together in ways never fathomed by small-business owners. Just a few of the benefits include:
- Helping children become self-reliant.
- Teaching small business-ownership skills.
- Instilling the concept of a job well done.
- Saving money in the business by not hiring outside help -- it’s money you were going to give them anyway.
- Teaching them how to complete a hard day’s work.
- And of course, saving taxes!
Will the Kiddie Tax Apply?
Simply stated: no. The “kiddie tax only” notion applies to unearned or “portfolio” income, not earned income from a job. Moreover, when it does apply, it’s imposed at the parents's tax rate and exists to prevent parents from moving assets with passive income into children’s names.
However, paying your children for working in the business or serving on the Board of Directors or Advisors is earned income. The children, young or old, get their own earned-income standard deduction and get taxed at their individual rate (oftentimes much lower than the parent’s rate). Get them involved!
Bottom line, the days of working on the family farm are continuing to disappear all across America, and more and more children are leaving the home without work ethic, money management skills and a concept of entrepreneurship. Small-business owners like you, the entrepreneur, have the perfect opportunity to pass on the American dream. Teach your children about small business, save taxes, pass on a legacy and realize that some of your most affordable and eager support is right there in the house eating at the dinner table with you.