A CREDO TAX PLANNING STRATEGY SOLUTION
CHILDREN AS EMPLOYEES: A Guide on the Tax Benefits and Legal Concerns
This whitepaper provides an in-depth exploration of the legalities and tax implications involved in hiring minors within your business. It offers insights on how integrating children as employees can facilitate the strategic redistribution of business earnings into their salaries, yielding notable tax benefits. Additionally, this guide covers the multifaceted advantages of this practice, including fostering early retirement savings for your children, providing them with valuable on-the-job experience, and laying the groundwork for effective succession planning.
Are you a business owner? Consider the strategic move of hiring your own children as legitimate employees, provided they are of working age. This approach not only offers a range of financial and business management benefits but also creates a rewarding experience for the entire family. However, it’s crucial to be well-versed in the legal aspects, employment regulations, and tax implications associated with employing minors. This guide aims to provide you with essential knowledge and best practices to navigate the complexities of hiring children under the legal maturity age in your business, ensuring compliance and maximizing benefits.
BENEFITS OF EMPLOYING YOUR CHLDREN
Retention Rates are Higher
Family-owned companies have considerably higher retention rates as compared to non-family-owned businesses. This is because family members cannot easily quit their families or their jobs. Family-owned firms are also likely to endure economic downturns more effectively as compared to the non-family businesses.
Great Tax Savings
Employing your children and have them do legitimate work would entitle you to deduct their salary from the income of the business and categorize it as a business expense (just like when hiring a non-child employee). Furthermore, if the child is under 18, there is no need to withhold or pay any FICA (Social Security of Medicare) tax on his salary (subject to a few exceptions). Given this rule, you may be able to shift a portion of your business income from your own tax bracket to your child’s (which is lower as compared to yours except if you are earning little to no income). So this results in substantial tax savings.
The next section will discuss more about the tax savings when hiring children in your business.
Better in Overcoming Business Challenges
There’s more flexibility when a business is owned, managed, and operated by a family because family members are eager to sacrifice more if there are business challenges. When there’s a cash flow crisis for example, family members are often willing to be flexible with payments.
With future tax rates being practically uncertain, one thing that we can confidently rely on when it comes to a child’s future tax rate is that if it is 0% today, any tax rate in the coming years won’t be any lower (with the possibility of becoming even significantly higher). So, in respect to long-term tax planning, “buying” the current low tax rate via a Roth IRA contribution typically makes sense.
There are two requirements when making a Roth IRQA contribution: the person must be below the applicable income threshold and he must have earned income. So children who are employed in a company will be eligible to make a Roth IRA contribution up to the lessor of $6,000 of their actual earnings. These early contributions could possibly have material impact on the retirement savings of the children (thanks to the power of the long-term compounded growth). For example, by merely contributing the maximum amount of $6,000 contribution to the child’s Roth IRA every year from 14 to 16 (three years worth of contribution), once the child reaches the age 65, he would have an accumulated about $500,000 of tax-free retirement money (assuming a 7% annual rate of return).
And with respect to Roth IRA contributions, children employees are not actually the ones making the contribution. They are allowed to keep all of their earnings while the parents’ money are separately contributing to the children’s Roth IRA (assuming that the parent has not yet capped out the annual gift limit to the children).
Work Experience for the Children
Employing your children in your business gives them helpful experience in the corporate world. This resume-type work can give them to edge when it’s time for them to seek employment opportunities elsewhere.
Building Familial Bonds and Forming Values
When you hire your children to work for your business, you are eventually demonstrating your values as you show them the importance of leadership, business resilience, solving problems, learning the value of earning money and work, and a committed workforce. What is even more rewarding is that you are building familial bonds with your children.
Eligibility for Other Employee Benefits
Children who are employees of your business are normally entitled to the same employee benefits of the company’s other employees (including HSAs, FSAs, and other retirement plans. These additional opportunities come with additional costs too so you have to plan accordingly if you are planning to hire children in your business. Take note that whenever you choose to give retirement plan or other employee benefits to your children, it should be applied across the board (i.e. you should make retirement contributions for the other children – other than your own – that you hire in your business).
Employing children in your company is one way to groom the next generation to take over your business and keep it within the family in the future.
TAX BENEFITS OF EMPLOYING CHILDREN
To maximize the tax benefits of employing your children in your business, it’s essential to meticulously document their work, wages, and employment records, mirroring the process used for non-family employees. Detailed insights into this will be explored in the subsequent section of this guide. To ensure you fully leverage these advantages, consider consulting with a Credo Certified Public Accountant (CPA). A CPA can provide a thorough evaluation of your specific circumstances, guiding you to optimize the benefits of integrating your children into your business workforce.
Significant Tax Savings When Shifting Taxable Income to Children Employed in the Business
Hiring minor children in a business gives you the ability to shift income from what is most probably the parents’ higher income tax rates to the children’s presumably lower rates. Children are able to have more income with the Tax Cuts and Jobs Act’s approximately doubling of the standard deduction (at 0% rate).
And notably, the so-called “Kiddie Tax” is of minimal concern here, as the Kiddie Tax is a tax levied on “unearned income”, such as interest, dividends, capital gains and distributions from inherited IRAs, 401(k)s, and other retirement accounts. In contrast, income generated from employment (including the parent’s) is considered as earned income. Therefore, the Kiddie Tax does not apply to such amounts, and the full amount of the Standard Deduction (and availability of lower tax brackets) is allowed.
Assuming that you own a small toy store and you are currently in the 35% tax bracket. You have three children (ages 15,16,17) and you are employing all of them to work for the year with each getting $12,500. The deductions for this would cut your taxable income by $37,500. That is $12,500 salary of each multiplied by 3 (children employees). You would then have a tax savings of $13,125 ($37,500 X 35% = $13,125). This amount is a tax savings alone (which is even greater than the salary of one of your children).
As an additional financial benefit, if your children don’t have any other income (other than the one that they earn from working in your business), then the entire $12,500 salary that is being paid to each child is 100% Federal-income-tax-free! So this is another savings for your business.
Tax savings can even be more significant when your business is at or near the new qualified business income (QBI) deduction phaseouts. As an example, the salaries of minor children in the business can help lessen the business owner’s taxable income to they are given a larger QBI deduction.
Additionally, the wages paid to minor children are counted as wages paid for the wages or wages-and-depreciable-property tests for the QBI deduction. This simply means that the wages of these children can slow down the phaseout of the QBI deduction for owners of SSTBs (Specified Service Trades or Businesses) with income within the phaseout range. This can also help in preserving up to the full QBI deduction for non-SSTB business owners who have income that are within or above their applicable phaseout range.
Increasingly, the business owner’s reduction of income via the payment of salaries to minor children, plus the likely increase in the owner’s QBI deduction can give the business the “right” set of facts and circumstances that are almost 50 cents of every dollar paid to a child in Federal taxes.
Payroll Taxes (on a Child’s Salary)
Apart from the regular income tax savings that you can get when paying salaries to minor children, the Federal tax law also provides potential savings on employment taxes. Sole proprietorships, single-member LLCs, and partnerships (but not corporations, including S corporations) where both parents are the only partners/owners of the business are specifically not required to pay Social Security or Medicare (FICA) taxes when the employed children are under 18 years of age. This particularly means that the children will not be accruing Social Security benefits based on those earnings either, nor do they start accumulating any quarters of coverage to be eligible for Social Security and Medicare benefits in the future.
Moreover, sole proprietorships, single-member LLCs, and partnerships where both parents are the only partners of the business are not accountable for Federal unemployment (FUTA) taxes on children under 21. Those businesses, conversely, may still be obligated to pay state unemployment taxes.
Furthermore, it’s imperative to note that even if a child-employee’s wages are not subject to FICA and/or FUTA, those wages are still subject to Federal withholdings (unless the child is otherwise exempt). Therefore, the children should still receive a W-2 from the business and they may to file a Federal tax return to be refunded for any excess amounts withheld (which would comprise of all of the amounts withheld if their employment income is entirely offset by the child’s Standard Deduction).
Children’s Employment Tax Savings (for Parents with Corporations)
Corporations (including S corporations) are not qualified for the special employment tax breaks on FICA and FUTA (even if a child’s parents are the only shareholders of the corporation). So parents (business owners) are given the following options:
Hire the Children Anyway: You may still opt to hire your children via the corporation and simply recognize the restrictions. The combined Social Security and Medicare taxes (15.3%) that would be payable on a child’s salary, plus the federal unemployment tax (6% on the first $7,000 of wages) would still “only” equal about 19% on a $12,500 salary. And apparently, at least some of the Medicare (or Social Security) taxes would have been paid by the parents if the income was allocated to them anyway. So, even with some FICA and FUTA tax duty, there would still be a tax savings to hiring the child in the business, particularly for higher-income business owner parents.
Modify Your Business’ Entity Structure: Another opportunity for a parent in such circumstance is to “scrap” the S corporation and turn the company into a sole proprietorship, single-member LLC, or partnership with the other parent. It’s very unlikely that such a change would be valuable exclusively for the purpose of avoiding employment taxes on a child’s – or even multiple children’s – salary. But given the numerous changes brought about the Tax Cuts and Jobs Act (which includes the potential benefits of non-corporate entity structures for specific business owners with respect to the qualified business income tax deduction), a modification in the entity structure may make sense anyway. The extra employment tax savings of hiring minor children in your business would just be an icing on the cake!
Form Another Business and Hire Minor Children on the New Company: This is a more aggressive strategy to save on employment taxes for parents who want to hire their children to work for their wholly-owned (potentially with the other parent) corporation. You have the option to establish a separate sole proprietorship (or single member LLC or partnership wherein both parents are the only partners) family management company. The said new company (which is employment-tax-savings-eligible family management business) would then
The separate employment-tax-savings-eligible family management company would then contract with the S corporation to provide services, and the family management company would then hire the children to provide those services (i.e. social media marketing, customer support, answering the phones).
For those who wish to use this work-around to avoid employment taxes on hiring minor children, properly keeping records is a must (contract and/or related documentation between the “regular” S corporation business and the newly formed family management company. This would convince the IRS to respect the entity.
With the family management company acting as the employer of the children, it means that it would have to run payroll, issue the W-2s, and file a tax return (likely a Schedule C). This additional work may counteract all or part of the advantages of establishment for some business owners.
RULES IN EMPLOYING CHILDREN
When considering the employment of children in your business, adherence to IRS regulations is crucial. The IRS closely monitors for cases where taxpayers claim benefits without legitimately employing their children. If the IRS determines that the children are not genuinely working, you risk losing tax deductions for their salaries and benefits, leading to tax liabilities on these benefits. However, employing children in actual work roles can be a tax-savvy strategy, especially under the Tax Cuts and Jobs Act (TCJA). Children can enjoy specific tax benefits on their earnings, with a typical deduction of $12,500 per individual as of 2021, making their earnings tax-free up to this amount. Even minors under 18 can contribute a portion of their earnings to a Roth IRA, offering further tax reduction opportunities. This approach not only benefits the children but can significantly enhance the business’s financial outcomes, particularly when employing multiple children.
1st Rule: The children must be bona fide employees
You must be able to prove that the children are your real employees and their work must be ordinary and essential for your business. Their salary must be for the actual services that they perform. You will only get business deductions for your children’s work performed on business property. You may assign some ordinary administrative work to your children such as answering phones, cleaning the office, and helping you with your website.
The IRS is also keen on the age of the children. An extremely young child is not acceptable to be a legitimate employee.
You should also have the children fill out timecards or timesheets to keep track of their work and hours that they perform the work. There should be proper documentation of the date, the services performed, and the time spent performing the services. It would also be helpful (although it is not legally required) that you have your children sign a written employment agreement which specifies his duties and assigned work hours. Take note that the duties on the agreement should only be related to your business.
2nd Rule: Pay the Children Reasonable Compensation
Paying the children when you hire them to do some work in your business is advantageous for your business because you can shift as much of your income as possible to the children (who are in a much lower income tax bracket). But their total compensation (sum of the salary plus all fringe benefits) must be reasonable. You have to find out how much other workers are getting paid for performing similar services in your area and you may use that as a basis of how much your children would be paid. Do not declare an exaggerated amount as salary to the children just to get a big tax deduction. As proof of payment to the children, you should pay them by check (not cash) and schedule the payments once or twice a month. The funds should then be deposited in a bank account under the children’s names (or your husband’s if you are employing your own children). The bank accounts of the children may be a ROTH IRA, Section 529 College savings plan or custodial account that you manage until your they turn 21.
3rd Rule: Compliance with Legal Requirements for Employers
When hiring children in your business, you must comply with the same legal requirements as when hiring a non-child employee. You must fill out IRS Form W-4 and complete U.S. Citizenship and Immigration Services (USCIS) Form I-9, Employment Eligibility Verification. The children’s Social Security numbers must also be recorded (have them apply for one if they don’t have it yet). As an employer, you should also have an Employer Identification Number (EIN) and you must also complete and file IRS Form W-2 showing how much you paid your children employees.
CHILD LABOR LAWS
Navigating the legal landscape of employing minors in your business requires understanding key regulations as outlined by the US Department of Labor. Central to these is the Fair Labor Standards Act (FLSA), encompassing various rules regarding working hours and compensation. These laws are designed to safeguard minors from overly strenuous work conditions, ensuring their well-being in the workplace. Staying informed about and compliant with these regulations is essential for any business engaging young employees, as it not only adheres to legal standards but also promotes a safe and fair working environment for all.
Require minors to have a work permit or working papers (many states do)
Limit the number of hours or times of day that workers 16 and over may work (many states do)
Apply if there is no FLSA employment relationship (if the child is not an employee)
Require breaks, meal periods, or fringe benefits (some states do)
Regulate discrimination, harassment, verbal or physical abuse, or morality (other federal and state laws do)
There are certain restrictions on employing children based on federal labor laws with each state having specific laws relating to child labor. Please check here your state’s child labor laws (as they may differ from federal laws). The rule is whichever is stricter or the most protective for the children in a specific situation would be applied.
Work Hours, Job Description, and Work Condition Restrictions
For minors age 16 and 17, they may perform any job not declared a hazardous job or occupation and are not subject to restrictions on hours.
For minors age 14 and 15, they may work outside school hours in different non-manufacturing, non-mining, non-hazardous jobs. This work has limitations on days and hours: No more than three hours on a school day, 18 hours in a school week, eight hours on a non-school day, or 40 hours in a non-school week.
Minors under age 16 may not start work before 7 a.m. or work after 7 pm, except from June 1 through Labor Day, when evening hours are extended until 9 pm.
Minors age 14 and 15 may work only in a restricted number of occupations: retail, food service, and gasoline service establishments specifically listed in the regulations.