We're not talking about an allowance – hiring your kids to help out your business could lead to major tax savings.
If you’re the owner of a business, there’s a good chance your kids will help out from time to time. How should you pay them, and what kind of tax advantages come with doing so?
The basics
- Your children can be officially employed by your business (if they’re doing real work)
- They can be paid
- up to the standard deduction ($13,850 in 2023) tax-free
- Your business can take a deduction without any tax liability on your child
Why hire your kids?
Officially hiring your kids isn’t just for convenient labor. Your business – and therefore your family – can save quite a bit on taxes this way.
| 📑 Note: When we say “kid,” we mean under 18. Any time you see “kid” or “child” in this article, it does actually refer to a legal minor. |
Basic deductions
To start off with, your child can take the standard deduction on their income taxes, which basically means they pay no income taxes on any wages up to $13,850 (in 2023). But you’re still able to deduct their wages from your taxable income as a business expense, meaning you can save on taxes without the money ever leaving your family.
Retirement funds
Since your child will now have some earned income, they can also make a $6,500 (in 2023) Roth IRA contribution, funds which grow tax-free until their retirement. Another great reason to set up a retirement plan for your business.
Payroll taxes
When you pay someone to work for your business, there’s two ways that can go: either they’re an employee or they’re an independent contractor.
That’s still true when paying your kids. So which one should you pick? Your best option depends on the way your business is structured and taxed.
You might see us repeat ourselves a bit – don’t worry, that’s on purpose.
Sole proprietorship (filed on Schedule C of your Form 1040)
If your business is taxed as a sole proprietorship, you don’t have to pay your kids like an employee. You also don’t need to issue them a 1099 at the end of the year, although they’re technically classified as independent contractors.
Just write them a check (or transfer money into their account) with a note indicating what the payment is for. That’s it! No W2s, no 1099s, you’re done.
Partnership (filed on Form 1065)
If your business is taxed as a partnership, your best bet depends on who the partners (owners/investors) are. Is it just you and your spouse? Or do you work with one or more partners who aren’t also the parents of your kid?
Scenario A – If you and your spouse are the only two partners
This works pretty much the exact same way as if your business was a sole proprietorship.
If your business is taxed as a partnership, and you and your spouse are the only two partners, you don’t have to pay your kids like an employee. You also don’t need to issue them a 1099 at the end of the year, although they’re technically classified as independent contractors.
Just write them a check (or transfer money into their account) with a note indicating what the payment is for. That’s it! No W2s, no 1099s, you’re done.
Scenario B – If one or both spouses work with other business partners
When your business is owned by more than just you and your spouse, you’ll need to pay your kids as an employee, including issuing a W-2 at the end of the year. That means that typical payroll taxes will need to be withheld from their pay – hence the W-2. It also means that they should file an income tax return (more on this below). You also have the option of setting up a family management company, which could allow you to avoid payroll taxes entirely.
If your business is taxed as an S-Corp (filed on Form 1120-S)
This is the same as Option B under partnerships above, so we’ll walk through that again: You’ll need to pay your kids as an employee (and issue them a W2 at the end of the year). That means that typical payroll taxes will be withheld from their pay. It also means that they should file an income tax return (more on this below). You also have the option of setting up a family management company, which could allow you to avoid payroll taxes entirely.
What’s a family management company?
The family management company (or FMC) is a structure that, if utilized correctly, can allow you to hire your children and still avoid payroll taxes, even when you’d normally have to pay.
Quick note: FMC isn’t an officially recognized term or anything. There’s no FMC box to check on the paperwork, It’s just a name for this type of strategy.
On a related note, we highly recommend that you don’t actually use the words “family management company” in any official documents.
How does it work?
Okay, so you’ve set up your family management company. Great. Now what? It’s simple:
- Your family management company will invoice your company for the services your kids are providing them.
- Once your family management company is paid, then you’ll pay your kids by writing them a check or doing a bank transfer (something that can be tracked). No payroll. No W2. No 1099.
- Your kids deposit their money.
If it’s that easy, why doesn’t everyone do it? Well, there’s a bit of a catch: the “substance over form doctrine”. This doctrine states that the substance rather than the technical form of a transaction governs its tax consequences. The IRS can collapse a series of transactions to get at what is really happening.
Sorry, that was pretty technical. Here’s the takeaway: your family management company can’t just exist on your tax returns. It needs to actually do something. If you’re simply going to pay your kids and your Schedule C will show zero profit, under audit you might have an issue. What we – and the IRS -- would rather see is that your family management company turns a profit. And have some expenses in there too!
This can be as simple as having the family management company charge an extra 10% on top of what your kids are being paid. Not too much, because any profit will be subject to self-employment taxes (aka payroll taxes). Just enough so that it’s seen as a separate business venture.
One point to be aware of here: You want to make sure that your FMC files its taxes as a sole proprietor on Schedule C of your Form 1040 – that’s your individual income tax return. This is super important because, if you don’t do this, then you won’t qualify for the additional tax savings.
Do I need an actual LLC for this?
Here’s your favorite answer: it depends!
For tax purposes, no, you don’t need a separate LLC for your family management company. Simply setting up a separate bank account and choosing a trade name will do.
However, we think it’s a good idea anyway – and your attorney will probably agree with us. Setting it up as a separate LLC is just safer. If you do go ahead and create the LLC, make sure it’s owned just by one parent.
Document everything!
This part is very important – make sure you are documenting everything. Paperwork is key. Everything should be documented appropriately so that if you are audited you can show invoices, pay slips, etc.
Another important detail: make sure the money actually moves in and out of all the appropriate accounts. It may seem like overkill when all the accounts are within the household, but if you’re telling the IRS it’s happening, it needs to actually happen.
What about the “kiddie tax”?
Yes, that’s a real thing. And the IRS does actually call it the “kiddie tax” on their official website.
Designed to discourage the wealthy from dodging taxes by transferring assets to their kids, this rule taxes a child’s unearned income (like capital gains distributions, dividends, interest income, etc) at the parent’s tax rate if it’s over the annual limit ($2,500 in 2023). This applies to children under the age of 18 or full-time students under the age of 24.
But this only applies to unearned income. So if you’re paying your kids to do an actual, real job … no kiddie tax!
Does my kid need to file a tax return?
We get this question a lot: “Do I need to file a tax return for my kids?” And the quickest answer is, once again, it depends.
If they received a W-2 from your business, then we would highly recommend that they file a tax return – it’s what you’re supposed to do. However, if you didn’t have to pay them via a W2, then chances are they don’t need to have a tax return filed.
However, even if they’re not technically required, a good general rule of thumb is to always file a tax return. If the IRS ever has any questions, you can point at the tax return you filed as evidence that you tried in good faith to get your taxes in order. We wrote an entire article on this too, so check that out.
More helpful tips
- Your kids have to be doing actual (age-appropriate) work for the business. There’s a lot of flexibility on what counts as legitimate work, but you can’t just make up fake stuff for them to do.
- Pay them fair wages for their work. Basically, the same thing you’d pay anyone else to do that job. Maybe a little more, because you love them and they're doing a great job (and you're not just saying that because they're your kid, right?).
- Write out a contract, record their hours, create a paper trail so the IRS can verify that everything is in order.
- Make sure you fill out IRS Form W-4 and USCIS Form I-9 for each kid if they are on payroll, or get a Form W-9 if they aren’t on payroll.
- They also will need a proper Form W-2, like any other employee would, if you did have to withhold payroll taxes.
| 📑Note: The I-9 is a document confirming that an employee is legally eligible to work in the United States. The W-4 is a document that establishes how much will be withheld from the employee’s wages for tax purposes. |
The bottom line
If you own a family business, hiring your kids is a great way to save on your tax bill while giving them a head start in life with some non-taxable income. As long as you’re following all of the IRS rules, you can save thousands on your taxes with no trouble. And giving them a little work ethic probably won’t hurt either.
Looking for assistance setting up your own FMC structure or implementing other great tax strategies? Schedule a call with one of our experts today.
