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Tax Benefits From Hiring Children to Work in the Family Business

June 15, 2015

Updated August 5, 2022

If you own a family business, employing your children may generate tax savings regardless of how the family business is organized. Here we cover some important things to know when taking this approach to your business.

Income Shifting

Business owners can turn some of their high-taxed income into tax-free or low-taxed income by employing their children. However, the children’s work must be legitimate, and the amount the enterprise pays them must be reasonable for the wages to be deductible.
 
For example, a businessperson in the 37% tax bracket for 2022 hires her 17-year-old son to help with office work full-time during the summer and part-time into the fall. He earns $12,950 during the year (and doesn't have earnings from other sources). If that $12,950 were paid to the parent, she would pay $4,791 (37% of $12,950) in income taxes. Instead, by paying the wages to her son, she saves this $4,791, plus her son pays no tax since he can use his $12,950 standard deduction for 2022 to completely shelter his earnings.
 
Family taxes are cut even if the child's earnings exceed his or her standard deduction. That's because the unsheltered earnings are taxed to the child beginning at a rate of 10%, instead of at the parent's higher rate.  

Kiddie Tax Implications

A business owner may also reduce their family’s kiddie tax liability by hiring their children to work for them.
 
The kiddie tax is a tax on the unearned income of a child, if certain criteria are met. The child will be subject to kiddie tax if the child’s earned income does not exceed one-half of his or her support and he or she is age 18 or is a full-time student between the ages of 19 and 23.
 
Thus, employing a child age 18, or a full-time student ages 19-23, could cause his or her earned income to exceed more than half of his or her support. This, in turn, could help to avoid the kiddie tax on the child's unearned income. Note that this earned income escape hatch from the kiddie tax only applies to children who are 18 or students ages 19-23.
 
Even if the kiddie tax applies, it only causes a child's investment income in excess of $2,300 (for 2022) to be taxed at the parent's marginal rate. It has no impact on the child's wages and other earned income, which can be sheltered by the child's standard deduction.

Retirement Plan Savings

Additional savings are possible if the child is paid more (or works part-time past the summer) and deposits the extra earnings into a traditional IRA. For 2022, the child can make a tax-deductible contribution of up to $6,000 to his or her own IRA. The business may also provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child's age, and the number of hours worked.
 
As a result, between the standard deduction and IRA contribution, a child can earn up to $18,950 in 2022 without paying any income taxes.
 
Alternatively, while not a savings on current-day taxes, a child could contribute to a Roth IRA and take advantage of the tax-free growth when they retire. The power of tax-free growth compounding could be significant. Though it will take your child many years to reap the benefits of this planning opportunity, they would be wise beyond their years to consider this strategy now.

Tax Savings Via Education Credits

Additional intra-family tax savings in the form of education credits may be available. By paying wages to their children, business owners may create opportunities for their children to claim education tax credits where the parents may be ineligible, due to modified AGI phaseouts.
 
For 2022, taxpayers may claim an American Opportunity Tax Credit (“AOTC”) equal to 100% of up to $2,000 of qualified higher-education tuition and related expenses, plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. Thus, the maximum AOTC is $2,500 a year for each eligible student, subject to phaseouts based on modified AGI.
 
The AOTC may be elected for a student's expenses for four tax years, and only for students who have not completed the first four years of post-secondary education as of the beginning of the tax year.
 
Taxpayers may elect a Lifetime Learning Credit equal to 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit for any taxpayer for a tax year is $2,000, regardless of the number of students for whom they have paid qualified amounts and is also subject to phaseouts based on modified AGI.
 
Where a parent pays the college education expenses of a child whom they claim as a dependent, only the parent may claim the education credits (if otherwise eligible). However, if a parent is eligible to but does not claim a student as a dependent, the student may claim the education credit for qualified expenses paid by them or the parent.

It may pay for a parent not to claim the student as a dependent if (1) the parent can't claim education credits because of high modified AGI, and (2) the student pays, or is deemed to pay the expense, and has sufficient tax liability (e.g., from summer or part-time employment) to claim the credit.
 
If a parent is eligible to claim a child as a dependent but doesn't, the child still cannot claim an exemption for themself.

FICA and FUTA

Employment for FICA tax purposes doesn't include services performed by a child under the age of 18 while employed by a parent. This can generate savings for a parent who runs an unincorporated business, including a single-member LLC.
 
For example, a sole proprietor who usually earns $120,000 from the business pays $5,000 to her 17-year-old child in 2022. The sole proprietor's self-employment income would be reduced by $5,000, saving her self-employment tax on the amount paid to her child. That's on top of the employee FICA that the child saves by working for a parent instead of someone else.
 
A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of their parents.
 
However, there is no FICA or FUTA exemption for employing a child in an incorporated business or in a partnership that includes non-parent partners. The children are subject to the same rules that apply to all other employees.
 
As you can see, many opportunities for savings exist when hiring your children. If you are a family business owner and are looking for ways to lower your tax liabilities, contact our experts.

 

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