Accelerate Your Child’s Path to Wealth
As parents, we want our children to get a head start in life. We’d like them to understand the value of work, develop a taste for entrepreneurship, and learn about investing. In this article, you’ll learn several ways to achieve these goals, and along the way you’ll discover a multitude of ancillary benefits for you and your family.
Hiring A Child Through a Business
Hiring your child through a parent-owned business is a great opportunity for you to bond with your child while imparting values, sharing experiences, and instilling a sense of financial independence. It also opens the door to financial rewards in terms of lower taxes and compounded investment returns.
Tax Advantages of Hiring Your Child
Hiring your child through a family owned business is a phenomenal way to lower the tax burden on your household. If done correctly and up to a particular wage threshold, the IRS will not require payroll taxes or income tax on earnings paid to your minor child. While there is ostensibly a requirement to withhold income tax, there is no income tax on income up to the standard deduction (after all, below this threshold the correct amount to withhold is zero).
Instead of you covering your child’s expenses with after-tax dollars, the business now pays your child and receives a tax-write off. And if your child makes less than the standard deduction (a generous $13,850 for the 2023 tax year), there’s no federal income tax income due. Paying your child means lower taxes for you, too, since you’ve now transformed a portion of business expense into household income that would have otherwise gone to the IRS.
Let’s assume you’re in the top tax bracket of 37%. If you were to employ each of your 3 teenage children at an annual salary of $13,850 through a sole proprietorship owned by you and your spouse, that would generate income of $41,550 shielded from federal income tax and over $15,000 in tax savings for your household.
Most state income tax rates will be low or negligible for workers earning less than the federal standard deduction. However, do check the filing requirements and income tax rates for your particular state.
Legal Basis
Many of my clients are surprised to learn they can hire their own children. Think back on all the family restaurants run with the help of minors. The legislation that makes this possible is the Fair Labor Standards Act (FLSA). This law exempts businesses wholly-owned by parents from most of the constraints associated with child labor laws when they employ their own children. Provided the work doesn’t involve hazardous activities such as manufacturing, mining, or roofing (!), your child’s employment is no longer subject to the usual limitations (i.e. number of hours worked, the time of day work is performed).
That said, be sure to check with your state’s department of labor to find out whether local restrictions on employing your children are more stringent than federal law. Whichever law is stricter will be the governing law.
Keeping It Real
The work your child performs must be legitimate and the level of compensation should be in line with market rates. In the table below you’ll find a sample of age-specific services children could perform for a parent-owned business.
Jobs for minors in family businesses:
Use the Right Structure
Wages paid to minor children who work for their parents are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child (see Figure 1). Payroll taxes would be due, however, if the child is paid by a C-corp, S-Corp, estate, or partnership in which at least one partner isn’t the child’s parent.
Fortunately, there is a work around if you use an S-Corp. It’s a matter of simply setting up a sole proprietorship as a “Family Management Company” (FMC) to render management services to the S-Corp. The S-Corp pays the FMC a management fee, and in turn the FMC hires your child wages and pays wages for services rendered.
Streamlined Documentation
While hiring your child through a parent-owned business is a relatively simple matter, the arrangement should be formally documented. We recommend you see to it that your files include a signed offer letter, job description, examples of comparable wage rates for similar positions found on employment sites, and, of course, records of hours worked and the type of work performed.
offer letter
job description
comparable wage rates for similar positions on the Internet
records of hours worked jobs performed
Since your child’s work is outside labor performed by a minor under the age of 18 for a qualifying parent-owned entity, there are no taxes to be withheld (no social security withholding, FICA, SUDA. FUD, and no worker’s compensation). And since there are no payroll taxes to be withheld and no federal income tax for those earning less than the standard deduction, there is no need or requirement to issue your child a W-2 or 1099.
Bank Accounts
Keep everything kosher by setting up separate bank accounts for each child employed and the entity or entities in your particular structure. Alternatively, you could open a custodial Roth IRA for your child and transfer wages to that account.
Benefits for Your Household
When documented correctly, your family keeps more of its hard earned money, the IRS receives less, and you and your child could also reap a long list of potential ancillary benefits:
For Your Child
Appreciation for the value of work
Taking responsibility for one’s expenses
Learning about taxation
Bonding with you through the business
Becoming an investor early in life
Reaping the benefits of compound interest
Saving for college or retirement
For You
Teaching your child about financial responsibility
Bonding with your child through the business
Tax write off for your business
Lower taxes for your household
A super-powered vehicle to build wealth for your child
The Power of Early Compounding
It’s claimed that Einstein once said compound interest is the most powerful force in the universe. Let’s take an example to get a feel for the potential growth. If your child were to earn $500 per month from age 12 to 17 and invest the money in a tax-advantaged account like a Roth IRA at, say, 8% per annum, by age 65 the savings will have reached over $1.9 million dollars.
The Roth IRA Tax Advantage
As you can see from the above example, Roth IRAs are an excellent way for your child to generate tax free investment income. And the beauty of a Roth is that withdrawals of contributions can be made at any time without any taxation or penalties.
The first requirement for funding a Roth IRA is to have earned income. If your child is working for your business, then they’ll have met this requirement. For the 2023 tax year, the maximum contribution is $6,500.
Since your child’s federal tax rate is low, say 0%, be sure to opt for a Roth IRA and not the traditional IRA. Remember, contributions to a Roth IRA are made with after tax dollars. If the rules are observed thereafter, one can avoid taxes on the withdrawal of both contributions and earnings. By contrast, contributions to traditional IRAs are made with before tax dollars, so withdrawals of both contributions and earnings would be subject to income tax at that future time.
Why have your kids pay federal income tax later when their tax rates will be higher? Instead, opt to have them pay taxes now when your their tax rate is 0%. This is a great way to help your child shift from a higher tax bracket to a lower one.
It’s also notable that with respect to Roth IRA contributions… while the child does need to have their own compensation to support the contribution, the child doesn’t actually have to be the one to make the contribution. Thus, should they desire to do so, a parent-employer can allow their child to keep all of their earnings, while separately contributing the parents’ own money into the child’s Roth IRA. (Presuming the parent has not already capped out his/her annual gift limit to the child.)
One last interesting point: while contributions to your child’s Roth IRA must not exceed the child’s earnings, the IRS does not actually require the child to fund the Roth directly. In fact, you could fund the account even though your child may have already spent his or her earnings for the year.
DisclaimerInformation provided reflects the views of TechView Wealth Advisors LLC as of the date of this document. Such views are subject to change at any point without notice. The information contained herein is for informational purposes only and should not be considered a recommendation to buy or sell any securities. Nothing presented herein is or is intended to constitute investment or tax advice, and no investment or tax decision should be made based on any information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.