Employing Your Children – It Could Be a Tax-savings Strategy and a Learning Opportunity

Do you have children you would like to keep busy after school or a college student who will soon be home for winter break? If you own your own practice or business, hiring your children can be a good business decision with financial benefits for you and your child.
One of the biggest incentives of hiring your children is the potential tax savings. The tax savings will vary depending on the type of entity your business is. If your practice is an unincorporated business (Schedule C/Self-Employed), you have the greatest potential tax savings. Your under-age-18 employee-child’s wages are exempt from FICA taxes (Social Security and Medicare taxes). This is a savings to both employer and employee of 6.2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} for the Social Security portion of the tax and 1.45{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} for the Medicare tax.
Also, wages paid to children under age 21 are exempt from federal unemployment taxes (FUTA). Both the FICA and FUTA tax exemptions also apply if your practice is a partnership or LLC, as long as the only partners are the parents. This is a big tax savings, as you would have to pay these payroll taxes on any other employee you hired. Furthermore, for higher-income taxpayers, the deduction for wages paid will reduce the amount of earned income subject to the extra 0.9{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} Medicare tax.
This does not mean there are no tax benefits if you are an S-corporation or C-corporation (or a partnership that includes non-parent partners). No matter what type of entity you are, you will get a business deduction for the wages paid to your children. As a corporation, you also get a deduction for the payroll (FICA/FUTA) taxes paid on their wages. These deductions reduce the amount of overall profit subject to federal and state income taxes for the C-corporation as well as the amount of the income that flows through to the shareholder/partner to be taxed on their individual return.

Tax Impact on the Children
Now let’s look at the tax impact on your children. If the wages paid to your children are equal to or less than the standard deduction ($6,300 in 2016), they will not owe any income taxes on their earnings. Even if you pay your children more than the standard deduction, there is typically still a tax benefit. Since your children are most likely in a lower tax bracket than you are, you are shifting income from your higher tax bracket to their lower one. In 2016, taxable income up to $9,225 is taxed at only 10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} for a single taxpayer. Also, earned income (wages) is not subject to the ‘kiddie’ tax.
Another advantage is that older children may be able to offset any taxes owed by education credits claimed on their own individual tax return. In many cases, the parent’s income is too high to utilize these education credits. In order for the child to claim any of the education credits, the parents may not claim them as a dependent on their tax return. This results in the parent losing the deduction for their personal exemption ($4,050 in 2016).
However, because the personal exemption deduction is subject to phase-out limits based on your adjusted gross income (AGI), you may not even be eligible to claim any personal exemptions. For 2016, married filed joint taxpayers will start to lose the benefit of the personal exemption when their AGI reaches $311,300, and it is completely phased out at $433,800. Assuming the child does have a tax liability, the overall tax savings is typically still greater when the child is able to claim the education credit.
Something else you should consider is having your children begin to save for their own retirement by investing some of their wages in a Roth IRA. In 2016, they may make a contribution to a Roth IRA of $5,500 or their taxable compensation, whichever is less. This is an excellent long-term tax savings investment for your child.

Bottom Line
The IRS is well aware of the benefits of hiring a child, so your child must be a real employee. There are no age limitations for employing your child, but the work performed must be necessary for the business, and the wages paid must be reasonable for the type of work performed. There could be a little more bookkeeping required as you should keep time sheets showing the dates, hours, and services performed. You will also need to file quarterly payroll tax reports and Form W-2 at the end of the year. However, if you have other employees, you are filing these already.
Everyone’s situation is different, but this can be a great tax-savings strategy as well as an opportunity for you to teach your child about your business and help them learn new skills, as well as begin to develop a sense of responsibility.