Employing A Business Owner's Children

One unique aspect of owning your business is the ability to hire your children. Whether doing so makes sense for you and your business is more than a business decision. For your children, the answer depends a great deal on your intentions for passing the business to future generations, the child’s interest and aptitude, and your feelings about how much a parent should “help” a child and how much they should “make it on their own.” However, some real benefits are available when you employee your children.

·         Reducing Income Taxes. Usually, children (especially minors) are subject to lower tax rates than their parents. In this case, shifting taxable income away from the parents and to their children is an effective way to lower the family’s tax burden. Many income-shifting strategies were effectively killed by the “Kiddie Tax,” which potentially taxes the unearned income of children under age 24 at their parent’s marginal rate. Fortunately, wages are earned income, so they are not subject to the Kiddie Tax. Also, children who are claimed as their parent’s dependents usually are limited to a standard deduction of $900 (for 2008). However, the standard deduction for a dependent with earned income equals his or her earned income plus $300 (up to $5,450 for 2008). Thus, up to $5,450 of earned income can be completely sheltered from tax. And, the next $8,000 of wages will be taxed at only 10%.

·         Funding an IRA for Your Children. Paying a child wages also means an IRA can be funded for that child (the funds can actually come from your child or from you as a gift). Thus, paying your child wages of $5,000 this year will allow the maximum amount to be placed in either a traditional or a Roth IRA for your child. However, a Roth IRA, which potentially allows all earnings to be tax-free, may be the best option if your child has a low current tax rate, a long horizon for saving, and will likely be in a higher tax bracket when distributions are eventually made. It may also be a good way to fund some of the child’s college costs as distributions are tax free up to the amount of contributions that have been made to it. In any case, the ability to compound income either tax-deferred or tax-free for many years is a powerful way to build wealth.

·         Reducing Payroll and SE Taxes. If your business is operated as a sole proprietorship (or partnership where you and your spouse are the only partners), employing your children under age 21 can reduce payroll taxes. This is because wages paid to a child under age 21 are exempt from the FUTA tax. They are also exempt from FICA tax if the child is under age 18. Furthermore, the wages reduce your self-employment (SE) income and, thus, reduce SE tax. (This exemption doesn’t apply if your business is operated as a C or S corporation, or as a partnership with partners other than your spouse.)

·         Executing a Business Succession Plan. It’s never too early to start planning to transition ownership of your business to the next generation. The business’s continued success depends on the existence of a capable and experienced successor to the owner. Furthermore, it’s important for your key employees to be confident in the abilities of your successor. Thus, if your children are your intended successors, it is critical that they become involved in the business several years before the ownership transition is made.

Wages paid to your child should be comparable to what would be paid to a nonfamily member for the same work otherwise the IRS is likely to question them. Also, the tasks performed should be reasonable based on your child’s age and skill level. While it may be possible for a 12-year-old or 13-year-old to work a few hours a week, it’s probably not realistic to pay that child more than minimum wage given his or her capabilities. Older children could likely be expected to work more hours and command a higher wage.

Employing your family members can have many benefits other than those we’ve described. Often, working together in the family business strengthens the family bond. Of course, aspects such as wanting children to learn to work for an unrelated employer and the reality of spending a great deal of time together also come into play. In many situations, employing family members makes good tax and business sense. Please call if you would like to discuss any of these matters at greater length.