How Much Can I Pay My Child From My Business?

Paying a child from a family business can offer distinct advantages for both the business and the child. This strategy allows parents to teach financial responsibility and work ethic, while potentially benefiting from tax planning opportunities. Structuring such an arrangement properly is important to ensure compliance with tax regulations.

Determining Fair Compensation

The Internal Revenue Service (IRS) requires that any compensation paid to an employee, including a child, be “reasonable.” This means the payment must be comparable to what an unrelated individual would receive for similar services in the same market. For example, paying a 16-year-old an industry-standard hourly rate for managing social media is generally considered reasonable, whereas paying a very young child a high wage for simple tasks might not be.

To determine a reasonable wage, consider the child’s age, skill level, and specific duties. The work must be legitimate and necessary business-related activities, not personal chores.

Factors to evaluate include the type of work, hours worked, and the child’s qualifications. Researching prevailing wages for similar jobs in your area helps establish an appropriate pay rate. Overpaying for simple tasks can raise red flags with the IRS, potentially leading to a denial of the business deduction.

Maintaining detailed records of the work performed and hours spent is important to substantiate wages paid. This documentation helps demonstrate the legitimacy of the employment relationship.

Tax Advantages for Your Business and Child

Employing your child can create several tax advantages for both your business and your child. For your business, wages paid to the child are generally deductible as a business expense. This deduction can reduce your business’s taxable income, thereby lowering your overall tax liability.

Specific payroll tax exemptions may apply depending on your business structure and the child’s age. If your business is a sole proprietorship or a partnership where only the child’s parents are partners, wages paid to a child under 18 are exempt from Social Security and Medicare taxes (FICA). Wages paid to a child under 21 are also exempt from Federal Unemployment Tax Act (FUTA) taxes under these same business structures.

These FICA and FUTA exemptions generally do not apply if your business is incorporated (C-corporation or S-corporation) or a partnership that includes non-parent partners. In such cases, your child’s wages are subject to these payroll taxes like any other employee’s wages. Regardless of business type or age, federal income tax withholding is generally required for your child’s wages.

For the child, earned income can be largely offset by their standard deduction, potentially allowing them to earn a certain amount tax-free. A child can earn up to the current standard deduction amount without owing federal income tax.

If the child’s earnings exceed the standard deduction, the excess income is taxed at their own marginal tax rate, which is typically lower than the parent’s rate. This income shifting can result in overall family tax savings. Earned income also makes them eligible to contribute to retirement accounts like a Roth IRA.

Essential Steps for Compliance

Establishing a legitimate employment relationship requires careful adherence to compliance steps. Formal documentation, including a clear job description outlining the child’s duties, ensures the work is defined and business-related.

Maintain meticulous records, including time cards or work logs detailing hours and specific tasks, similar to any other employee. Payroll records, such as pay stubs and W-2 forms, must be accurately kept and issued annually.

Payments to the child must be made directly to them, such as via check or direct deposit into their own bank account. This demonstrates the funds are the child’s income, not an allowance or gift. Funds should not be used for family expenses or deposited into a parent’s account.

For payroll, obtain an Employer Identification Number (EIN) from the IRS if your business does not already have one. This number is required for businesses with employees to report taxes. Your child will also need to complete Form W-4 for federal income tax withholding and Form I-9 for employment eligibility verification.

Treating your child as a genuine employee, distinct from an informal arrangement, is important. Establish a proper employer-employee relationship with defined roles, regular pay, and appropriate documentation. These practices help avoid scrutiny from tax authorities and ensure the validity of claimed deductions or exemptions.