Can You Pay Your Kids Tax-Free From Your Business?

Paying children for legitimate work within a family business can offer distinct tax advantages for both the business and the child. Understanding the specific rules and requirements is important for navigating this financial strategy effectively.

Employing Children in Unincorporated Businesses

When a parent employs their child in an unincorporated business, such as a sole proprietorship or a partnership where the parents are the only partners, specific payroll tax exemptions may apply.

For wages paid to a child under 18, the business is exempt from Social Security and Medicare (FICA) taxes. Wages paid to a child under 21 are exempt from Federal Unemployment Tax Act (FUTA) taxes. These exemptions mean neither the employer nor the child needs to contribute to these federal payroll taxes.

These payroll tax exemptions apply only if the business is a sole proprietorship or a partnership where both partners are the child’s parents. The work performed by the child must be legitimate, ordinary, and necessary for the business, and the compensation paid must be reasonable for the services rendered. For instance, tasks like office assistance or website maintenance can be suitable.

While FICA and FUTA taxes may be exempt, federal income tax withholding still applies to the child’s wages. The child’s wages will be subject to federal income tax above their applicable standard deduction. Deducting the child’s wages as a business expense can reduce the business’s taxable income and potentially lower the owner’s self-employment tax liability.

Employing Children in Incorporated Businesses

The tax treatment for employing children differs when the business is incorporated, such as an S-corporation or a C-corporation. In these structures, the payroll tax exemptions available to unincorporated businesses generally do not apply.

Wages paid to a child by an incorporated business are subject to FICA and FUTA taxes, regardless of the child’s age. This is because a corporation is considered a separate legal entity from its owners. The employer-employee relationship within an incorporated business is treated the same as with any other employee for payroll tax purposes.

The requirement for the child’s work to be legitimate, ordinary, and necessary for the business, with reasonable compensation, remains in effect for incorporated businesses. Income tax withholding rules also apply to the child’s wages.

Understanding the Child’s Income Tax Liability

Regardless of the business structure, the child’s earned income from employment is subject to their own income tax rules. A key advantage for the child is the standard deduction for dependents. For the 2024 tax year, a dependent’s standard deduction is the greater of $1,300 or their earned income plus $450, up to a maximum of $14,600. This means a child can earn income up to this threshold without incurring federal income tax liability.

The “kiddie tax” generally does not apply to a child’s earned income. It primarily targets unearned income, such as interest, dividends, and capital gains, to prevent parents from shifting investment income to their children’s lower tax brackets. Since wages are considered earned income, they are taxed at the child’s own tax rate, not the parent’s marginal rate.

A child with earned income can contribute to a Roth IRA. Contributions are made with after-tax dollars, and qualified withdrawals in retirement are tax-free. For 2024 and 2025, the maximum annual contribution limit for a Roth IRA is $7,000, or 100% of the child’s earned income, whichever is less. This allows for tax-advantaged savings and growth, providing a head start on retirement planning.

Essential Compliance for Employing Children

Establishing a genuine employer-employee relationship is important when hiring a child in a family business. This involves defining a clear job description, setting regular work hours, and providing supervision, similar to how any other employee would be managed. The work must be necessary for the business, and wages paid must be reasonable for the services performed.

The business must obtain an Employer Identification Number (EIN) if it does not already have one. Accurate payroll records, detailing hours worked and wages paid, are important for compliance and substantiation. At the end of the year, a Form W-2 must be issued to the child, reporting their wages and any taxes withheld.

Compliance with federal and state child labor laws is necessary. These laws dictate minimum age requirements for employment, limitations on work hours, and prohibitions on hazardous occupations, with some exceptions for parental employment. For instance, federal law places restrictions on working hours for children under 16. It is advisable to consult state labor department resources, as state laws may be more restrictive than federal guidelines, and the more rigorous standard applies. Maintaining thorough documentation, including time sheets and proof of payment, is important to substantiate the legitimacy of the employment and wages in the event of an audit.