Hire Your Child And Shift Some Opportunity, Responsibility And Wealth

By: Randall A. Denha, J.D., LL.M.

Many people hire their children for a variety of reasons.  Some of these are to create and instill a strong work ethic, teach responsibility, teach them about entrepreneurship and save some taxes!  As the IRS’s own website itself says: “One of the advantages of operating your own business is hiring family members”. That family member can be a spouse, sibling, parent, or even a child. In fact, while hiring a child may not seem like a top-of-mind move for many business owners, if you play by the rules, there can be a surprisingly broad array of tax (and other) benefits to doing so!

Thanks to the Tax Cuts and Jobs Act of 2018 (TCJA), your employee-child can use his or her standard deduction to shelter up to $12,200 of 2019 wages paid by your business from the federal income tax. This amount has doubled from prior years. So, children employed in a family business can earn that much in income and enjoy a 0%(!) tax rate on their income (at least for Federal tax purposes), all without facing the Kiddie Tax (which only applies to unearned income). In addition, many states will also permit children employed in the business to avoid unemployment (FUTA) taxes, and children working for their parents’ sole proprietorship, partnership, or LLC and may also avoid employment (FICA) taxes as well (which can be a material tax savings for many families, and especially those with high-income parental business owners). So under the new law, your child can shelter almost twice as much wage income with the increased standard deduction. That makes hiring your kid a better idea than ever. Your child can then set aside some or all of the wages (earned income) and contribute money to a Roth IRA or a college fund. More on this strategy is discussed below.

Depending on the type of entity you operate your business within, there are different rules. While FICA and FUTA may be avoided with entities other than corporations, no such exemption exists under FICA and FUTA for a corporation. So, if your business is a corporation, the IRS rules are clear that payroll taxes be paid on income given to your children.

Does this mean that you shouldn’t employ your children if your business is a corporation from a tax standpoint?  No.  Here is a possible work around: form a family management company (i.e. sole proprietorship, LLC or partnership) and pay the children directly from it.  The new entity would enter into a management agreement with the corporation, receive management fees and pay the children from the management company, free from the corporate payroll.

The caveat, though, is that employing a child in the business still requires that he/she do bona fide (age-appropriate) work in the business (i.e., a “real” job), for a “reasonable” (and not excessive for tax purposes) wage. The work must also comply with both Federal Fair Labor Standards Act (FLSA) rules (which fortunately are fairly flexible for parents employing their children in their own wholly-parental-owned business), and state child labor laws as well.

When you hire your child, you get a business tax deduction (for employee wage expense) for money you might have just shoveled out to the kid anyway. The deduction reduces your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable).

So, with your child’s earnings, what can he/she do with the money besides spending it on the latest version of Fortnite? A Roth IRA is one answer.

The Roth IRA angle

The only tax-law requirement for your child to make annual Roth IRA contributions is having earned income for the year that at least equals what is contributed for that year. Age is completely irrelevant. So if your child earns some cash from a summer job or part-time work after school, he or she is entitled to make a Roth contribution for that year.

Specifically, for the 2019 tax year, a working child can contribute the lesser of: (1) his or her earned income or (2) $6,000. While the same $6,000 contribution limit applies equally to Roth IRAs and traditional deductible IRAs, the Roth option is usually better for kids for the reasons explained below.

By making Roth contributions for just a few years during teenager-hood, your child can potentially accumulate quite a bit of money by retirement age. Here’s what could happen.

• Say your 15-year-old contributes $1,000 to a Roth IRA at the end of each year for four years. Assuming a 5% annual rate of return, the Roth account would be worth about $33,000 in 45 years when the “kid” is 60 years old. If you assume a more-optimistic 8% return, the account would be worth about $114,000 in 45 years.
• Say the kid contributes $1,500 at the end of each of the four years. Now the Roth account would be worth about $49,000 in 45 years, assuming a 5% rate of return. With an 8% return, it would be worth about $171,000.
• Say the kid contributes $2,500 at the end of each of the four years. Assuming a 5% return, the Roth account would be worth about $82,000 in 45 years. Assuming an 8% return, the account value jumps to a whopping $285,000. Wow!

You get the idea. With relatively modest annual contributions for just a few years, Roth IRAs can be worth eye-popping amounts by the time the “kid” approaches retirement age.

Why the Roth IRA is usually the better IRA option

Because many kids don’t earn enough money to benefit from the up-front tax deduction associated with traditional IRAs, it makes sense in most cases to focus on Roth IRAs. In general, the Roth IRA is the IRA of choice for minors who have limited income and who, therefore, would not benefit from a deductible, traditional IRA.  That’s because, as explained earlier, an unmarried dependent child’s standard deduction will automatically shelter up to $12,200 of 2019 earned income from federal income tax. Any additional income will almost certainly be taxed at very low rates. So unless the child has enough taxable income to owe a significant amount of tax (not likely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless. Since that’s the only advantage a traditional IRA has over a Roth account, the Roth option almost always comes out on top.

There are two different types of IRAs that are suitable for children: traditional and Roth. The primary difference between traditional and Roth IRAs is when you pay taxes on the money that you contribute to the plan. With a traditional IRA, you pay taxes when you withdraw the money during retirement (at your then-applicable tax rate). All the funds, both your contributions and any earnings they’ve accrued, are considered pre-tax in a traditional IRA. With a Roth IRA, you pay taxes when you put the money into the account, so the funds – the contributions and their earnings – are considered after-tax money. The money grows tax-free while it’s in either a traditional or Roth IRA. But the benefit of a Roth is that when the child withdraws the money many decades from now, he or she won’t have to pay income tax on it. What’s more, there are no required minimum distributions (RMDs) on the money. Of course, these rules may change in the next 40 years, but that’s where they are now.

The bottom line

While hiring your child can be a tax-smart idea, remember, however, that the child’s wages must be reasonable for the work performed. So this strategy works best with teenage children who can be assigned meaningful tasks. Keep the same records as for any other employee to substantiate hours worked and duties performed (e.g., timesheets and job descriptions), and issue your child an annual Form W-2 just like any other employee.