How to Pay Your Child a Salary From Your Business

Paying a child a salary from a family business offers financial advantages and teaches valuable lessons in financial responsibility. Proper implementation requires understanding the conditions for legitimate employment and the specific tax implications for both the business and the child. This strategy can be a beneficial financial tool when managed correctly.

Establishing Legitimate Employment for Your Child

Establishing a child’s legitimate employment is fundamental to realizing tax benefits. The work must be genuine, necessary for the business, and age-appropriate. For instance, administrative tasks like data entry, website maintenance, social media management, or cleaning the business premises can qualify as legitimate work. The IRS scrutinizes arrangements where work is trivial or made-up, potentially disallowing deductions if not properly substantiated.

Compensation paid to the child must be reasonable, comparable to what an unrelated employee would earn for similar services in the open market. Paying excessive wages can lead to the IRS reclassifying payments as non-deductible gifts or dividends, negating intended tax advantages. Business owners can research industry averages or consult staffing agencies to determine appropriate wage rates for the duties assigned.

Age plays a significant role in payroll tax obligations, particularly FICA and FUTA taxes. If the business operates as a sole proprietorship or a partnership where both partners are the child’s parents, wages paid to a child under 18 are exempt from FICA taxes. This exemption extends to FUTA taxes for children under 21 in the same business structures.

However, if the business is incorporated (C-corporation or S-corporation) or a partnership with non-parent partners, the child’s wages are subject to FICA and FUTA taxes regardless of age. Federal income tax withholding is required for the child’s wages in all business structures, irrespective of age. Properly classifying the business type and understanding these distinctions is essential for accurate payroll and tax compliance.

Understanding Tax Benefits and Obligations

Legitimate employment creates distinct tax implications for the child and the business. For the child, earned income is taxed at their individual income tax rates, generally lower than the business owner’s. A significant benefit is the ability to utilize the standard deduction, which for single filers is $14,600 in 2024 and $15,000 in 2025. This means a child can earn up to this amount without incurring federal income tax liability.

The “Kiddie Tax” is designed to prevent income shifting to exploit lower tax brackets, primarily applying to unearned income like interest, dividends, or capital gains. Wages earned by a child for actual work are considered earned income and are not subject to Kiddie Tax rules. For unearned income, the first $1,350 in 2025 is tax-free, the next $1,350 is taxed at the child’s rate, and amounts above $2,700 are taxed at the parent’s marginal tax rate.

For the business, wages paid to the child are a deductible business expense. This deduction reduces the business’s taxable income, which lowers the overall tax liability for the owner. This includes federal income tax and, for self-employed individuals, self-employment taxes.

The business may be exempt from paying the employer’s share of FICA and FUTA taxes on the child’s wages under specific conditions. These payroll tax savings can further enhance the financial benefits of employing a child.

Essential Documentation and Record-Keeping

Proper documentation is crucial to substantiate the child’s employment and payments for IRS compliance. An employment agreement or job description should outline the child’s specific duties, expected hours, and agreed-upon compensation. This formalizes the employment relationship and demonstrates that the work is legitimate.

Accurate time tracking is necessary, requiring detailed records of hours worked by the child. This can be accomplished through timesheets or work logs, similar to those maintained for any other employee. Such records provide concrete evidence of services performed and justify wages paid.

Payroll procedures for a child employee must mirror those for any other team member. This includes obtaining a Form W-4 from the child to determine appropriate income tax withholding. If applicable, a Form I-9 is also required to verify the child’s eligibility to work in the United States. The business must also have an Employer Identification Number (EIN) to handle payroll and tax filings.

At the end of the tax year, a Form W-2 must be issued to the child by January 31st of the following year, reporting their total wages and any taxes withheld. Issuing a Form 1099-NEC is generally not appropriate for a child acting as an employee, as that form is used for independent contractors. Establishing a separate bank account in the child’s name to deposit their earnings can further reinforce the legitimacy of the payments and demonstrate the child’s control over their funds.

Maximizing the Child’s Earnings

Once a child earns legitimate income from the family business, strategic opportunities arise to maximize earnings. A particularly advantageous option is contributing to a Roth IRA for the child. Since Roth IRA contributions must come from earned income, the child’s salary makes them eligible. Contributions to a Roth IRA grow tax-free, and qualified withdrawals in retirement are also tax-free, making it an attractive long-term savings vehicle, especially given a child’s likely low tax bracket. For 2025, the contribution limit for a Roth IRA is $7,000, or 100% of the child’s earned income, whichever is less.

Other investment avenues include traditional IRAs, offering potential tax deductions on contributions, though withdrawals in retirement would be taxed. Custodial accounts, such as Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts, can also be used to invest the child’s earnings. These accounts are managed by an adult until the child reaches a certain age (typically 18 or 21, depending on the state), when the child gains full control. However, income generated within these custodial accounts is unearned income and may be subject to Kiddie Tax rules if it exceeds specific thresholds.

Beyond retirement savings, earned income can be directed towards other future expenses. While contributions to a 529 college savings plan are gifts and are not tax-deductible for the contributor, the child’s earned income can provide the means for the child or parent to make these contributions. This allows for tax-advantaged growth for educational expenses, providing flexibility for future planning.