Hiring your children to work in the family business is a smart tax move – for you and for them

You are newly self-employed and your children have no school in the summer. Hmmm. Do you have one or more young employees who could do useful work for your company? If so, hiring your child – or several of your children – can yield some nice tax benefits. With the kids leaving school and likely to be fully available for the next few months, this is a timely story. Forget those swimming and tennis lessons you may have thought about. Let the damn kids work. They need to learn about capitalism, and the sooner the better. Here’s what you need to know about the tax implications.

Tax advantages for your child

You run your business as a sole proprietorship, as a one-man limited liability company that is treated as a sole proprietorship for tax purposes, as a spouse partnership, or as a limited liability company that is treated as a spouse partnership. Big. That means you can hire your child under the age of 18 as a legitimate worker and their wages are exempt from Social Security tax, Medicare tax, and federal unemployment tax (FUTA). In fact, the FUTA tax exemption lasts until your employee’s child turns 21. You can hire your child part-time, full-time, or whatever works.

The standard deduction of your dependent worker child can protect up to $12,950 of wages received by your company from federal income tax in 2022. Kind.

bottom line: Your child owes the Fed none of the first $12,950 in wages unless they have income from other sources. The child can then set aside some or all of their wages and put money into a Roth IRA (more on that later) or college fund.

Tax advantages for you

If you hire your child, you’ll get a business tax deduction – for the employee’s wage costs – for money you might have just given the child anyway. The deduction reduces your federal income tax bill, your self-employed tax bill, and your state income tax bill, if applicable.

When your company is registered

What if you operate your business as a corporation? If so, your child’s wages are subject to Social Security, Medicare, and FUTA taxes like any other worker. However, several tax credits are still available. You can deduct your child’s wages as a business expense on your corporation’s tax return; Your child can protect wages from federal income tax with the standard $12,950 deduction; and your child can put a portion of their earnings into a Roth IRA or college fund.

Playing the Roth IRA angle

The only tax requirement for your child to make an annual Roth IRA contribution is income for the year at least equal to what is paid in for that year. Age doesn’t matter at all. So if your child earns some money with a holiday job or a part-time job after school, it is entitled to contribute for this year.

For the 2022 tax year, your child may contribute the lesser of: (1) his or her employment income or (2) $6,000. While the same $6,000 contribution limit applies to a Roth IRA and a traditional deductible IRA, the Roth option is almost always better for children for reasons explained later.

Small contributions to the Roth IRA for children can really add up

If you contribute to Roth for just a few years as a teenager, your child can save quite a bit of money by the time they reach retirement age. Realistically, however, most children will not be willing to contribute the annual maximum of $6,000, even if they have sufficient income. Try persuading a teenager to save big instead of spending it all. Much luck. So, as a realistic parent, you must be satisfied if you can convince your child to make at least one meaningful contribution each year. The following could happen.

* Suppose your 15-year-old pays $1,000 into a Roth IRA at the end of each year for four years. Assuming a 5% annual return, the Roth account would be worth about $33,000 in 45 years when the “kid” is 60 years old. Assuming a more optimistic return of 8%, the account would be worth about $114,000 in 45 years.

* Assume the child deposits $1,500 at the end of each of the four years. Now, 45 years from now, the Roth account would be worth about $49,000 assuming a 5% return. At an 8% yield, it would be worth about $171,000.

* Assume the child deposits $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 have the idea With relatively modest annual contributions for just a few years, Roth IRAs can be worth staggering amounts as the “child” nears retirement age.

For children, Roth IRAs are almost always better than traditional IRAs

It is usually a much better idea for a child to contribute to a Roth IRA than to contribute to a traditional deductible IRA for a number of reasons. First, your child can deduct all or a portion of their annual Roth dues — with no federal income tax or penalty — to pay for college or for other reasons. But Roth merits can generally not be obtained tax-free before the age of 59. On the other hand, if your child makes deductible contributions to a traditional IRA, all subsequent withdrawals must be included in gross income. Worse still, traditional IRA withdrawals made before the age of 59 are subject to a 10% early withdrawal penalty tax, unless an exemption applies (one exception is paying qualifying college expenses).

Important point: Although your child can receive Roth contributions without adverse federal tax consequences, it is best to leave as much of the Roth account balance as possible until retirement age in order to accumulate a larger income tax-free amount.

What about tax deductions for traditional IRA contributions you ask? Isn’t that an advantage over Roth IRAs? Good question. There are no write-offs for Roth contributions, but your child is unlikely to receive any significant write-offs from contributions to a traditional IRA either. That’s because, as previously explained, the standard unmarried dependent child deduction automatically protects up to $12,950 of earned 2022 income from federal income tax. Any additional income will almost certainly be taxed at very low rates.

So if the child doesn’t have enough taxable income to owe a significant amount of tax (probably not), the theoretical benefit of being able to deduct traditional IRA contributions is mostly or entirely worthless. There is the only Because of the advantage a traditional IRA has over a Roth account, the Roth option for children almost always comes out on top.

The final result

As you can see, hiring your child can be a tax-wise idea. And with the job market tight, it’s probably a lot easier to hire a family member now than an outsider. Also, hiring your child keeps more money in the household.

However, remember that the child’s wages must be reasonable for the work done. So the hire-your-kid strategy works best with teenage children who can be assigned meaningful tasks.

Maintain the same records as any other employee to demonstrate hours worked and tasks performed (e.g., timesheets and job descriptions). And be sure to issue your child a 2022 Form W-2 early next year, just like you would any other employee. Hiring your children to work in the family business is a smart tax move – for you and for them

Brian Lowry

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