WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
We all hear people talk about how paying your kids is a game changer as a small business owner….it’s true, it can be an effective tool…so let’s dive into how this actually works & when it’s appropriate (and when it’s not).
So first off, why is paying your kids an effective tax strategy? We’ll use an example.
Let’s say you are a small business owner making $345,000 per year (meaning this net business income shows as 1099 income and you file a Schedule C) and you have two kids aged 10 and 11. You want to pay them each $13,000 per year for “cleaning/administrative tasks.” The first tax benefit to this strategy is that the $26,000 that you pay them gets deducted from your income as a business expense/write off….so now your schedule C income is only $319,000…Cool!
Next, this income/salary will show up on your kids’ tax return. But here’s the crucial part: because this amount of income fits under the standard deduction, it will all be taxed at the zero percent tax rate. (As a refresh, the first $14,000 of your income, as a single taxpayer, gets eaten up by the standard deduction and brings your taxes down to zero on this tranche of income. Everyone filing a tax return has the ability to use this standard deduction to lower their adjusted gross income.)
So effectively, you’re moving this income from your own tax return (which would be taxed at the 32% tax rate) and you’re moving it to your kids’ tax return which will, most likely, fall under the standard deduction and be taxed at a zero percent rate. This strategy, in this example, would mean approx. $8,320 in tax savings.
So that’s WHY it works…but let’s talk about some rules/ideas behind how to make it work for you because you have to be realistic & use common sense when implementing this strategy effectively.
- First off, you can’t pay your kids $50,000 per year for “office cleaning” if you’ve never paid anything close to that for cleaning prior to hiring your kids. I mean, you can….but this is going to be a giant red flag to the IRS. You have to make sure that you’re paying your kids an appropriate salary for the work they’re doing and a good way to gage that is by asking the following two question: “what would you pay someone else to do this similar type of work?” and then “Is this a function that normally exists in my business?”
- The work that you’re hiring your kids’ to do has to be age-appropriate and be something that they actually are capable of doing. A 9-year-old is not going to be handling your bookkeeping or putting together presentations for clients. But maybe they’re good on the computer and they’re able to upload/edit your marketing videos or they’re able to organize your files, clean the office, do administrative tasks, or post pre-approved content to social media. (These are some of the most common tasks we see kids’ doing for their parents businesses.)
- The youngest example we have to work off (in terms of the youngest age a child can realistically work in your business) is a 7-year-old. There’s an IRS case study of a 7-year-old being deemed eligible to work in their parents’ business…the IRS said this was acceptable. So, this is thought of, broadly, as the minimum age that you can start going down this road. Again, this isn’t a rule/law, but a lot of tax practitioners will use age 7 as a “best practice” based on case study precedent. (You also should check the child labor laws in your individual state.)
- Younger than this, the only thing you can really hire your kid for is as a model for your website, marketing videos, storefront pictures etc., and, again, I would just caution using common sense here. Does your business really “derive income” based on the pictures of your kids? Do you have other “models” that you also work with or have hired in the past? Is this actually a core part of your business? Are you using one picture of your kid on your website and paying them $13,000 for a single shot? That will not pas muster. And then if you’re paying them a small amount for a few pictures, is that even worth it? Again, once you stretch things in this way, you start to create risk for yourself…I just don’t think any of it is worth the potential liability/hassle from the IRS. (I don’t file tax returns but that is not a strategy I would be comfortable putting my name on a return.)
- All of this is almost beside the point…because you should ACTUALLY be hiring your kids to do the work, document their hours and responsibilities, and then figure out their total pay after the fact. You should not be figuring out how much to pay the kids’ FIRST and then back in the responsibilities/hours to make it fit.
- To that end, you don’t want to pay your kids exactly what you need to in order to maximize the benefit while fitting under the standard deduction. So in 2023 the standard deduction is $14,000….so you don’t want to pay your kids’ $13,850 per year….that’s just a giant red flag…that’s a clear sign that you’re clearly after the maximum tax benefit and you might just be trying to squeeze a round peg in a square hole to get there.
- A quick note: If you have an S Corp (and so already have payroll), there will be a bit extra to navigate because you would have to pay your kid out of the S Corp, which would mean paying FICA (Social security & Medicare) taxes which would be 7.65% for your child and 7.65% for you as the employer…so that 15.3% would cut into the tax utility of doing this. If you’re a sole proprietor, since person LLC, or a partnership (only applies if the other partner is your spouse) these taxes wouldn’t apply (there’s an exemption under age 18) so it’s a bit more straight forward to pay them.
I hope this is all helpful to think about. From my own perspective (and experience), I think the primary benefit of hiring your kids should be the experience they get in learning a skill and the values & work ethic that you can inculcate in your kids through hard work and the sense of accomplishing a task.
If this is the starting point, it becomes a lot simpler & comfortable to benefit from the tax benefits mentioned at the start…because you actually will have the records, the hours log, and the details to put forth your case if ever questioned by the IRS.
As is always my point in these emails, the main takeaway should be about proactivity. Get intentional with your finances. Get educated in your tax planning. Speak to a professional to find out what you’re missing….You don’t know what you don’t know!
Feel free to reach out or schedule time on my calendar here.