Putting Your Children to Work

If you run a business in which you are able to hire your children to help you, then paying them wages for the work they do, will teach them many lessons.  It will help them put aside money and additionally it can help save taxes for you.

Since the IRS is likely to look closely at any family relationship, it is important that your children actually render services to your business in order for the business to get a deduction for the wages paid to them.  Documentation should be maintained showing that your children actually performed the services for which they were paid and the work was necessary for the business.  Even a relatively young child can provide services, answering the telephone, or performing simple secretarial or clerical tasks.  The wages paid to them must be “reasonable, ” that is age-appropriate and not more than the going rate for unrelated employees who may perform comparable work.  It is important you treat your children the same as you would other employees, by keeping records showing amounts paid and hours worked.  The payments you make to your children are not subject to the “kiddie tax.”  Under the “kiddie tax,” the investment income of a child under age 14 is generally taxed at the parents’ top rate when the investment exceeds $1,600 for 2004 (this amount is adjusted annually for inflation).  Since the “kiddie tax” does not apply to wages a child earns, paying your child a wage is an excellent income shifting tax reduction strategy.  The wages paid to a child, regardless of age, are deductible by the business and taxed to the child at his or her rate.

The child is entitled to the standard deduction  ($4,850, up from $4,750 in 2003) for 2004.  The standard deduction will offset the child’s investment income to the extent of no more than $800, but will offset wages to the greater extent of $4,850.  As a result, the standard deduction will provide a way to shelter $4,850 from taxation, while at the same time providing your business with a tax deduction.

An added benefit is no social security tax will be required for certain types of entities.  If you conduct business as a Sole Proprietorship or as a husband-and-wife partnership, the compensation paid to your under-age-18 children are not subject to social security and Medicare taxes that aggregate 15.30% (7.65% for both employer and employee).  If the business is incorporated, or you have a partnership with a partner other than your spouse, this break will not be available.  An added advantage to paying your child is that you can leverage the payments with a retirement account.  Each year the child can put as much as $3,000 (for 2004) of his or her wages into a regular or a Roth individual retirement account (IRA).  The “above the line” deduction for a regular IRA may not be worthwhile, since the child’s tax bracket is likely to be low.  However, this should not stop the child from contributing to a Roth IRA whose contributions will grow without being taxed and can be withdrawn by the child at any time, though the earnings will be subject to a penalty if withdrawn before age 59 ½.  Early retirement contributions by a child are a powerful tax deferred method to build wealth over time.

As a parent, you are still eligible to take an exemption for your child even if you pay wages to him or her.  This is regardless of how much he or she receives from earnings and other sources, as long as your furnish more than ½ of his or her total support for the year.  For 2004, the exemption amount is $3,100.  However, this exemption may be of limited benefit if your exemptions are phased out as a result of your income level.

The non-tax benefits enjoyed by you and your child, who works for you in your business, are just as valuable.  The child learns the value of earning their own money, but, possibly more important, your children will have the opportunity to see for themselves what you do.  It will provide a unique way for you to spend time with each other, as well.  The non-monetary rewards, plus the multiple tax benefits, make this a winning strategy that you do not want to overlook.