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Tax Breaks for Hiring Your Children

by
Gordon W. McNamee
on
8/11/2016
Tax Breaks for Hiring Your Children

Introducing the next generation into the family business is a time-honored tradition – a mainstay of American entrepreneurship. Many of the country’s most successful businesses have passed the mantle to offspring who have started learned the business from the ground up at an early age.  Not only is this a great way to build family bonds and instill a strong sense of responsibility – it also makes tremendous financial sense. When a dependent child under the age of 19, or who is a full time student under the age of 24, is able to do a job and the job duties are an appropriate responsibility for them, it keeps the business’ revenues within the family while at the same time reducing the amount of taxes assessed on the parents for self-employment income.

 Advantages of Hiring Your Child

The numbers make the tax advantages of hiring your child crystal clear: For tax year 2016, you can employ your child and pay them up to $6,300 without them owing a penny in income tax on what they have earned. If you pay them more than that, the tax rate is just 10% for the next $9,275 – and if they are under the age of 18 the amount that you pay them has no payroll tax assessed against it.

Contrast this against the rules that apply to a dependent child’s investment income, which – if above the threshold of $2,100 -  is taxed at the top marginal rate that their parents are subject to, and children have a lower $1,050 standard deduction.  Though the “kiddie” investment income tax rate works against a child, the tax on earned income is treated much more advantageously, at the child’s marginal rate. A dependent child can choose between reducing their earned income by either the regular standard deduction of $6,300 or taking their earned income and adding $350, and then choosing whichever is lower.

This is how a child who has no other income can earn $6,300 without having to pay taxes on it.

 To understand how this works, consider the example of a family-owned, unincorporated business that places the parents in the 25% tax bracket. By hiring their child and paying them $11,800 during tax year 2016, they not only eliminate their own tax burden on the amount that they pay (25% of 11,800 = $2,950), but their child only has to pay $550 in taxes on the same amount of money ($11,800 – the $6,300 standard deduction = $5,500, and 10% of $5,500 = $550). It is a net savings for the family of $2,400.

 At the same time that you are teaching your child the business and the value of work, you are successfully shifting your income as a self-employed business owner – with all of the taxes that go along with it – to your child. As long as the job that they are doing is appropriate and legitimate, and the amount that you are paying them is reasonably reflective of the amount of work that they are doing and the responsibility that they have, this is a perfectly acceptable strategy. 

Additional Incentives

Not only does hiring your child reduce your family’s tax burden, but unincorporated businesses whose owners employ their children under the age of 18 can eliminate the business tax burden that they would carry if they hired an adult employee in their stead – and the child doesn’t have to pay the share that an adult employee would have to pay either. These taxes include FICA, Social Security and Hospital Insurance or Medicare.

What kind of savings does this represent? Taking the same family-owned, non-incorporated business referenced above, a business with profits of $130,000 not only reduces the taxes that it pays on self-employment income by $11,800, but also eliminates its Hospital Insurance/Medicare self-employment tax burden (2.9% times the SE factor of 92.35%), which based on $11,800 amounts to $316 that no longer needs to be paid.

If the business’ net profits fall below the 2016 maximum SE income of $118,500, there would also be savings on the 12.4% tax assessment for Social Security. Earnings paid to a child under the age of 21 who is employed by their parent are also exempt from having to pay federal unemployment tax, even if the business consists of a partnership between both parents alone. It is important to note that these exemptions are not applicable if the business partnership involves parties beyond the parents, or if the business is incorporated.

The Retirement Plan Bonus

In addition to all of the advantages cited above, the benefits of hiring a child can be extended even farther. If the child’s earnings go beyond the standard deduction, up to $5,500 of their additional income can be placed into a traditional IRA. This contribution would be tax deductible. Doing this would mean that your child could earn $11,800 per year with no income tax ramifications at all, but it is important to look at this option carefully. In the example provided above, the tax burden that would be assessed on the child without making a contribution to an IRA would only have been 10% of 5,500, or $550. 

Since a traditional IRA investment would only provide $550 in savings, it may make more sense to invest the $5,500 in a Roth IRA, which provides greater tax-free retirement benefits. Additional savings may even be realized by including your child on your company’s retirement plan, but the availability and advantages of this are largely dependent upon the plan, your child’s age, how many hours they work, and more.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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