When you are self-employed, regardless of your entity structure, you must give heed to succession issues. Hiring your children, no matter their age, is a first step in determining whether or not the child is willing or suitable to carry on the family business.
But there are issues to consider when it comes to picking a person to take the reins.
If your business is a sole proprietorship or a partnership in which each partner is the parent of the child, and the child is under the age of 18, then you are not required to withhold and match Social Security and Medicare taxes on the child’s pay. If the services the child provides are domestic work in the parent’s private home then you needn’t withhold until the child reaches the age of 21. The child’s wages are not subject to FUTA tax.
If your legal form is corporate, even if you and your spouse are the only shareholders, you must withhold Social Security and Medicare taxes. You may have to withhold income taxes if the child earns more than $50 in a quarter or if the child isn’t regularly employed to do the work.
Depending on how much your child earns working for you combined with other sources of income, it’s possible the child will be required to file an income tax return – even if you still qualify to take the child as your dependent. Refer to IRS Filing Requirements for Children to make the determination.
No matter the age of the child, be sure to formalize the business relationship or payment to the child to avoid any problem during an audit. I once represented a taxpayer who paid the child in cash and did not have timesheets or any other record of the child’s activity, and the IRS disallowed the deduction.
Here are some steps to ensure the deduction.
1. Have your child complete and sign Form W4
2. Have your child keep regular timesheets
3. Provide a performance review
4. Write a job description
5. Pay by check
If you follow these steps, if the IRS comes a knockin’ you will have documentation to support the deduction.
Make sure the pay to a child is reasonable. Over the years many clients have come to me suggesting a tax strategy that goes something like this: My son is off to college this fall and I’ll be paying about $30,00 in tuition, can I just pay that out of the business, call it wages and write it off? After all, I make too much to enjoy the American Opportunity Tax Credit.
The answer is no. But I certainly appreciate their reasoning. The American Opportunity Tax Credit is a pretty big deal. But year after year I see that the clients who can afford to put their kids through school are the ones who can’t enjoy the credit because they make too much money. According to the IRS, the full credit is available to individuals whose modified adjusted gross income is $90,000 or less, or $180,000 or less for married couples filing a joint return. The credit is phased out for taxpayers with incomes above these levels.
The kid can’t get the credit either if he/she is taken as a dependent on his parent’s tax return.
But let’s put a legal spin on this. If you legitimately hire your child and pay them well – and I’m talking a reasonable wage for the work performed let’s not overdo it – then let the child make his $30,000, file a tax return on his own without indicating that his parents are claiming him as a dependent, and enjoy the tax credit ($2,500 max), 40% of which may be refundable. So even if he has no tax liability, he may still enjoy a refund. As the parent you lose the dependency status but you gain the deduction for wages paid to the child.
If you wish to hire your child, check with your tax professional to discuss the strategies that will prove most beneficial to all concerned.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.