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Hiring your kids in your business is an incredible tax planning strategy, but it's also a great way to teach them about business as well. It’s also a way to save for your children’s college education. Since hiring your children is a tax planning strategy, there are some specific rules you need to follow to avoid running afoul of the IRS.

Wages paid to your children are a valid business deduction, as long as they do bona fide work and they are compensated fairly. The age range for hiring your children is 7 years old (the IRS suggested minimum age for employment) and older. However, there may be legitimate cases where you can employ even younger children, such as in business advertising.

How To Qualify For The “Hire Your Kids” Strategy

The duties performed by your children must be in connection with the business, or performed in the business. In other words, you can’t pay them a wage for doing chores around the house and deduct that wage from your business. Officially, you should draw up an employment agreement documenting the duties that your child will perform, and the amount he or she will be compensated for those duties.

The employer should also keep track of the hours that the child works, similar to a normal non-family employee. To do this you should use a time card to track your child’s hours worked. You should pay the child a reasonable wage for those duties. You should pay them the same amount (or less) that you would normally pay a non-family member to do the same duties, but never pay them more than you would pay a non-family member.

You should complete a W-4 for your children when you hire them and pay them from your business checking account to document your children’s pay. You should also provide them with a W-2 at the end of the year and file quarterly payroll reports, even though tax may not be due.

The money that you pay your child must be used as they wish; otherwise, it will not be considered as valid compensation by the IRS. That means you can't force your child to use the money to save for college. If you do want to use these wages for college tuition, however, you should set up a separate bank account for the child and write checks for the college tuition from that child’s personal bank account.

Benefits Of The “Hire Your Kids” Strategy

Hiring your children is a great way to either fund a college savings account or even directly pay college tuition when the student is attending school. Once your children have earned income, they can also start saving for retirement. There are a number of accounts they can use to save for college, including a 529 account, a Coverdell Education Savings Accounts, an IRA, or a UGMA or UTMA account.

If you earn too much to qualify for a Hope or Lifetime Learning tax credit, you can allow your child to claim one of these credits. While the child cannot be claimed as a dependent on the parent’s tax return, the overall family tax savings gained from letting a child claim an education tax credit is usually greater when compared to tax loss the parents incur by not claiming the child as a dependent on their tax return. Furthermore, earned income is not subject to the ‘kiddie tax’, so you don’t have to worry about having to report your child’s income on your tax return and pay taxes at your higher tax rate.

The children can also use their earned income to build a savings account or even a retirement account. In 2017, your children can contribute up to $5,500 of their earned income to a traditional IRA or a Roth IRA, and $12,500 to a SIMPLE IRA. A traditional IRA will allow them to shelter any income earned above the $6,350 standard deduction from taxes, but a Roth IRA may offer greater tax benefits since the earnings are tax-free as long as your child follows the withdrawal rules.

Tax Savings Involving The “Hire Your Kids” Strategy

The basic tax benefit of hiring your children comes from effectively shifting income from your higher tax bracket to their lower tax bracket. Because most children are in a lower tax bracket (10%-15%) than you are, you can save money by hiring them and paying them wages, then have them purchase items that you would normally purchase with your own money; such as college tuition.  

If you are self-employed and your child is under age 18, you don't have to pay Social Security or Medicare payroll taxes on their wages. If they are under age 21, you do not have to pay unemployment taxes on them. This is a huge tax savings since you would have to pay these taxes on any other employee you hired.

In 2017, earned income below the standard deduction is not subject to tax, so your child can essentially earn up to $6,350 before he or she will owe any income tax. Most children are in the lowest tax bracket, which is 10% for taxable income under $9,325 in 2017. Since most parents who own their own business are in a higher tax bracket, ranging from 15% up to 39.6%, by paying your child a wage, you are effectively shifting income from your higher tax bracket to their lower tax bracket. This is a great way to reduce your family’s total tax liability.

Furthermore, paying your kids a wage may reduce your own AGI, which could allow you to claim tax deductions and credits for which you might not otherwise qualify. For example, the phase-out for the Child Tax Credit starts at $110,000 for married taxpayers filing a joint return. If you can reduce your adjusted gross income to below $110,000 by paying your child a wage, this could allow you to claim a larger child tax credit.

Example Of The “Hire Your Kids” Strategy

In 2017, Tom paid his 16-year-old son $6,350 (the standard deduction amount) in wages for work on Tom’s business website. Since his son’s earnings are equal to the standard deduction amount, the son does not owe income taxes on his earnings. In addition, because his son is under age 18, Tom does not have to pay Social Security, Medicare or unemployment taxes like he would with a regular employee.

Tom currently pays 25% in federal taxes, 6% in state taxes and 15.3% in self-employment taxes, for a total tax rate of 46.3%. Because Tom can deduct his son’s wages from his business profit, Tom saves $2,940 in taxes ($6,350 x 46.3%). Tom normally gives his son $6,350, or more, over the course of a year for personal items. By employing his son and paying him wages instead, Tom can save considerable money in taxes. This is an incredible tax planning strategy for small business owners with children under the age of 18.

Let’s take it one step further. Let’s assume Tom paid his 16-year-old son $11,850 in 2017 and his son puts $5,500 of the wages into a traditional IRA and the remaining $6,350 into a bank account. Using this strategy, Tom’s son still does not owe a dime in taxes and has saved $11,850 that he can use for upcoming college expenses. In turn, Tom now saves $5,486 in taxes ($11,850 x 46.3%) on money that he would have normally used to pay his son’s college expenses.

Note: Tom’s son would owe taxes on the $5,500 IRA once the money was withdrawn for college expenses, but those taxes would be little, or none. Furthermore, there is no tax penalty on money withdrawn from an IRA, if the money is used for qualified college education expenses.

Implementing The “Hire Your Kids” Strategy

• Step 1: Determine the duties, develop a reasonable compensation for the child, and set up a systematic payroll (bi-weekly, monthly, quarterly, or yearly).
• Step 2: Execute an employment agreement with the child – when hiring your child you need a formal hiring process that should include the completion of a standard Employment Application, W-4 form, and an I-9 form.
• Step 3: Set up a separate checking account in the child’s name to deposit the earnings. This account must be separate from the parents’ bank account.
• Step 4: Record the child’s services performed using a monthly time sheet.
• Step 5: Pay child using a business check each month
• Step 6: Deposit child’s check into the child’s checking account each month
• Step 7: Issue monthly payroll tax reports – IRS Form 941
• Step 8: Issue IRS Form W-2 to child each year of employment
• Step 9: Fill out a yearly Form IRS Form 1040 for the child

Documents Used To “Hire Your Kids”

The following are the documents you will need to Hire Your Kids in your business:

• Employer identification number (IRS SS-4 Form)

• Employment Application, W-4 form, and an I-9 form

• Monthly time sheets

• Monthly payroll tax reports (IRS Form 941)

• Issue IRS Form W-2 to the child each year of employment

• IRS Form 1040 for the child