Can I Pay My Kids From My Business? Rules to Know

Employing a child in a family business offers valuable work experience and potential financial advantages. Navigating specific regulations is important to ensure compliance and maximize benefits.

Establishing Legitimate Employment

The Internal Revenue Service (IRS) scrutinizes family employment arrangements to ensure they are legitimate business expenses, not wealth transfers. Work performed by a child must be ordinary and necessary for the business, meaning tasks a non-family employee would typically perform, directly contributing to business income.

Compensation paid to the child must be reasonable for services rendered, reflecting what an unrelated individual would earn for similar work. Excessive wages or “make-work” tasks could lead to deduction disallowance. The work must be genuinely required by the business, not ordinary household chores.

Proper documentation of the child’s employment activities substantiates the arrangement’s legitimacy. This includes a clear job description, a record of regular work hours (timesheets or project logs), and evidence of work completed. These records demonstrate the child is a bona fide employee.

A child’s age influences the type of work they can perform and associated tax implications. Federal labor laws, such as the Fair Labor Standards Act (FLSA), set minimum ages for employment and restrict minor work hours. Generally, children must be at least 14 for most non-agricultural jobs, with specific rules for hazardous occupations.

Business structure impacts payroll tax exemptions for family members. For a sole proprietorship or partnership where parents are the only partners, wages paid to a child under 18 are generally exempt from Social Security and Medicare taxes (FICA). This means neither the employer nor employee portion of FICA taxes needs to be withheld or paid.

Wages paid to a child under 21 by a parent’s sole proprietorship or partnership are also exempt from Federal Unemployment Tax Act (FUTA) taxes. These federal payroll tax exemptions offer an advantage for these business structures. However, these FICA and FUTA exemptions generally do not apply if the business is incorporated, such as an S or C corporation.

Understanding Tax Treatment for Your Business

Legitimately employed child wages are a deductible business expense. This reduces the business’s taxable income, leading to a lower tax liability for the owner. The deduction amount equals the gross wages paid, provided compensation is reasonable for the work performed.

For sole proprietorships and partnerships, federal payroll tax exemptions provide an advantage when employing a child. Wages paid to a child under 18 are exempt from Social Security and Medicare taxes (FICA). This means the business does not incur the employer’s share of FICA taxes, nor does it withhold the employee’s share from the child’s wages.

Wages paid to a child under 21 by a parent’s sole proprietorship or partnership are also exempt from Federal Unemployment Tax Act (FUTA) taxes. This exemption means the business avoids paying the federal unemployment tax, which funds unemployment benefits. These exemptions can result in payroll tax savings for the business.

These FICA and FUTA exemptions generally do not apply to businesses structured as corporations (S or C corporations). If incorporated, child wages are subject to FICA and FUTA taxes, like wages paid to any other employee. The corporation is responsible for both employer’s and employee’s FICA shares, as well as FUTA taxes.

While federal payroll tax exemptions apply to sole proprietorships and partnerships, state-specific payroll taxes may still be applicable. Many states have their own unemployment insurance programs and other mandated payroll taxes. Business owners should research their state’s specific requirements, as these may still need to be paid even if federal exemptions apply.

Understanding Tax Treatment for Your Child

Wages received by a child from their parent’s business are earned income subject to federal income tax. The child reports this income on their own tax return if gross income exceeds certain thresholds. Tax owed depends on total earned income and available deductions.

A benefit for the child is the ability to use their standard deduction to offset earned income. For dependents, the standard deduction is generally limited to the greater of a specific base amount or their earned income plus an additional amount, up to the standard deduction for single filers. This means a child can earn money without incurring federal income tax liability.

If a child’s earned income is below their standard deduction amount, they may owe little to no federal income tax. This allows the child to retain more of their earnings. The child must file a federal income tax return if their gross income exceeds their standard deduction or if they have unearned income above a certain threshold.

The “Kiddie Tax” generally applies to a child’s unearned income (interest, dividends, capital gains) that exceeds a specific threshold. This tax aims to prevent parents from shifting investment income to their children for lower tax rates. Since wages are earned income, the Kiddie Tax typically does not apply to the child’s employment wages.

Paying a child from the business does not automatically prevent the parent from claiming the child as a dependent. As long as all other dependency tests are met (relationship, age, residency, support, and joint return), the parent can still claim the child. The child’s income may impact their ability to pass the support test if they provide more than half of their own support.

Setting Up Payroll and Maintaining Records

Before paying a child as an employee, the business must have an Employer Identification Number (EIN) from the IRS. An EIN is a unique nine-digit number assigned to businesses for tax purposes, required for reporting wages and other payroll-related activities.

Once the EIN is obtained, setting up a payroll system is the next step. This can involve using dedicated payroll software, a professional payroll service provider, or manual management. A payroll system ensures accurate wage calculation, hour tracking, and proper withholding, even if FICA and FUTA exemptions apply.

Several forms are required for payroll and tax reporting. The child (or parent on their behalf) must complete Form W-4, Employee’s Withholding Certificate. At year-end, the business must issue Form W-2, Wage and Tax Statement, to the child, reporting annual wages and any taxes withheld.

For businesses not exempt from FUTA or FICA taxes, or for income tax withholding, forms such as Form 940 (Employer’s Annual Federal Unemployment Tax Return) and Form 941 (Employer’s Quarterly Federal Tax Return) are necessary. If FICA and FUTA exemptions apply, the process for these forms may differ, potentially requiring no reporting of the child’s wages on them, depending on the business’s overall payroll.

Meticulous record-keeping is important for substantiating legitimate employment and defending against IRS inquiries. Records should include detailed job descriptions, signed employment agreements, timesheets or logs of hours worked, pay stubs, and records of payments made (e.g., canceled checks or bank transfer confirmations). These documents provide concrete evidence of the employment relationship and services performed.

Payment to the child should be made through a formal method, such as a check, direct deposit, or payroll card, rather than cash. This reinforces the legitimate employer-employee relationship and provides an auditable payment trail. Treating the child as a formal employee, with regular paydays and proper documentation, helps maintain the arrangement’s integrity.