Small business owners can save family income and payroll taxes by putting their child (or children) on the payroll.
Here are a few things to know.
Converting business earnings into low-taxed income
Shifting some business earnings to a child as wages for services performed can turn some of your high-taxed income into tax-free or low-taxed income. However, the work done by the child must be legitimate and the child’s salary must be reasonable in order for the wages to be deducted as a business expense.
Say, for example, that a sole proprietor in the 37% tax bracket hires their 16-year-old son to help with office work, and he earns $10,000 during the year, without having other earnings. The sole proprietor can now save 37% of that $10,000 (or $3,700) in income taxes—and the son can still use his $12,550 standard deduction to shelter his earnings for the 2021 tax year.
In addition, the unsheltered earnings will be taxed to the son beginning at a 10% rate, instead of being taxed at the proprietor’s higher rate, which means that family taxes will be lowered even if the son’s earnings exceed his standard deduction.
Withholding income tax
Hiring your child means that your business will likely have to withhold federal income taxes on their wages.
Generally, employees can claim exempt status if they didn’t have any federal income tax liability for last year and don’t expect to have any this year. However, an employee can’t claim exemption from withholding if:
- They can be claimed as a dependent on someone else’s return
- Their income exceeds $1,100 for 2021, and includes more than $350 of unearned income
It’s worth noting that your child will probably still receive a refund for part or all of the withheld tax when filing the year’s tax return.
Saving on Social Security taxes
Services performed by children under the age of 18 while employed by a parent aren’t considered employment for FICA tax purposes. As such, it’s also possible to save some Social Security tax by hiring your child and shifting some of your earnings to them, as long as your business isn’t incorporated.
There is also a similar but more generous exemption for FUTA (unemployment) tax that exempts earnings paid to children under the age of 21 if they’re employed by a parent.
Both of these exemptions can also be applied when a child is employed by a partnership consisting only of their parents.
However, it’s worth noting that there’s no FICA or FUTA exemption for employing your child if your partnership includes non-parent partners or your business is incorporated. Still, there’s no extra cost to your business if you pay a child for work you’d otherwise be paying someone else to do.
Retirement benefits
Depending on how your plan defines qualifying employees, your business may also be able to provide your child retirement savings. Under an SEP plan, for example, a contribution of up to 25% of the child’s earnings (not to exceed $58,000 for 2021) can be made for the child.
Contact us today
Keep in mind that rules about employing children might change from year to year and could require changes in your income-shifting strategies. If you have questions about how to apply these rules to your situation, contact us today.