I’ll give you $3,003 if you will pay your child $6,350 to work for you. Would you be interested in this proposition?

That’s what federal and state governments paid Sara Jackson when she paid her 13-year-old child $6,350 to work in her Schedule C business.

Had Sara operated her business as a corporation, state and local governments would have paid her corporation $1,650.

The $3,003 that Sara received and the $1,650 that the corporation would have received came from the built-in hiring-your-child tax breaks that we discuss in this article. And depending on you and your family, you can generate numbers vastly exceeding the $3,003 and $1,650.

Zero Taxes for the Child

First, let’s examine Sara’s child. The child pays zero federal taxes on the

$6,350 of earned income. Wow! That’s nice. Sara gets the tax deduction and pockets $3,003, and her child has $6,350 in tax-free dollars.

What makes the child’s taxes zero? The standard deduction—this is the deduction in lieu of itemizing deductions for mortgage interest, property taxes, charitable contributions, etc. The 2017 standard deduction for a single taxpayer is $6,350.¹

Note This

All the money remains in the family. Sara paid her child $6,350 in wages. The child has that money. The federal and state governments paid Sara $3,003 in tax cash (refunds or reductions in taxes). The family has all the money: $9,353 ($6,350 + $3,003).

Why Hire Your Child?

Hiring your child gives you the opportunity to work with someone you know, love, and trust.

If you give money to your child and/or plan to help your child pay for college, the hire-your-child strategy is a big assist. First, you get a tax deduction for the wages, whereas just giving money to your child has to come from after-tax dollars.

Second, your child can put earned income into either a traditional or a Roth IRA. That money grows tax-free. If the child wants to use the money for college, he or she can take the money from the IRA, penalty-free. This is a huge break.

Pay More, Say $11,850

Say Sara wants to pay her child $11,850 and keep it tax-free for her child. Is this possible? Yes.

Here is how the child gets to zero federal taxes:

· The child puts $5,500 in a tax-deductible traditional IRA.²

· The $6,350 standard deduction eliminates the remaining $6,350. There’s nothing left to tax.

And here’s how Sara benefits. The federal and state governments pay Sara

$5,132 in after-tax cash for hiring her child.

Pay Even More—Say, $21,175

If Sara pays her child $21,175, and he puts $5,500 in a tax-deductible traditional IRA, the child’s federal tax is $933 and state tax is $220.³ After taxes, the child has $20,022 ($5,500 of which he has in the separate IRA account).

With this W-2 payroll, the federal and state governments pay Sara $10,016 in after-tax cash (14 percent in self-employment tax savings, 28 percent in federal income tax savings, and 5.3 percent in state income tax savings).⁴

Big Picture—Mechanics

Let’s look at what happens with Sara and her son:

1. Sara writes W-2 payroll checks to her son totaling $21,175. She is out this cash. The child now has $20,022 of this cash, and the governments have the remaining $1,153, which they collected in taxes from the child.

• Sara’s federal and state tax benefits from her $21,175 W-2 wage to her soncreate after-tax cash money of $10,016. She puts this money in her bank account.

• Sara’s son has taxable income after the IRA and standard deductionscreating a total tax of $1,153, leaving him with

$20,022, $5,500 of which is in the IRA.

Note that the family has $30,038 at this point ($20,022 + $10,016).

What Happened to the Payroll Taxes?

Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to Social Security and Medicare taxes if the trade or business is taxed as a sole proprietorship or a partnership in which each partner is a parent of the child.⁵

The parental proprietorship and partnership hiring rules also exempt wages paid to a child under the age of 21 from unemployment taxes.⁶

If you operate your business as a single-member LLC taxed as a proprietorship or as a spouse-only LLC taxed as a partnership, the IRS allows the beneficial parental treatment of payroll taxes. For more on how this works, see IRS Now Says No Payroll Taxes on Family Employment in a Single- Member LLC.

Corporate Treatment Is Different

Corporations do not qualify as mothers or fathers of the children, and therefore the payrollbreaks do not apply to wages paid by the owner’s corporation to the owner’s children.

In the introductory part of this article, we mentioned that had Sara operated as a corporation, the net tax benefit of the corporate hire would have been

$1,650, compared with a tax benefit from the proprietorship’s hire of $3,003. That difference in benefits reflects the Social Security and Medicare taxes inflicted on both the corporation and the child, as well as the unemployment taxes inflicted on the corporation.⁷

Choice of Entity Consideration

The difference in tax benefits when you hire one or more of your children is one of the differences that you need to consider when choosing an entity for your business. Depending on your choice of operating entity, here are three things to know:

1. Putting your under-age-18 children to work in your proprietorship or aspouse-only partnership pays off for both the owners and the children.

2. Putting your under-age-18 children to work in your S corporation or C corporation also pays off, but to a lesser extent because of the payroll taxes.

3. The difference in benefits can tilt the scale in your choice of business entity from corporation to proprietor or vice versa. You may have to put pencil to paper here. Also, the children will get older each year, and thus you have toagain look at the choice-of- entity scale as that happens.

What about the Kiddie Tax?

The kiddie tax does not apply to earned income. It applies to unearned

income.⁸

How Young Can the Child Be?

Tax law has no minimum age. The IRS approved the hiring of a seven-year- old in its acquiescence to the Eller case.⁹

Mr. and Mrs. Eller owned and operated mobile home parks. They hired their three children, who were 7, 11, and 12 years old. In its acquiescence, the IRS noted the following:¹⁰

1. Compensation is deductible only if it is reasonable in amount, actually paid, and based on services actually rendered.

2. The fact that payments are made to minor children by their parents does not preclude deducting the payments.

The acquiescence in this case means that the IRS accepts the holding of the court and that the IRS will follow the court’s decision in disposing of cases with the same controlling facts.¹¹ It does not indicate approval or disapproval of the reasons assigned by the court for its conclusions.¹²

For you, this means that you need proof that the amount you are paying your child is a reasonable amount for the services actually rendered.

Child Labor Laws

Parents employing their children are mostly exempt from the labor laws. The Fair Labor Standards Act provides that youth younger than 16 years of age working in a business solely owned by their parents or by persons standing in place of their parents can work at any time of day and for any number of hours.¹³ But parents are prohibited from employing their child in manufacturing or mining or in occupations that involve the following activities declared hazardous by the Department of Labor:¹⁴

• Manufacturing and storing of explosives
• Driving a motor vehicle and being an outside helper on a motor vehicle (other than the delivery of newspapers to consumers where youth are exempt from the labor laws¹⁵)
• Logging and sawmilling
• Working with power-driven woodworking machines
• Being exposed to radioactive substances
• Working with a power-driven hoisting apparatus
• Working with power-driven metal-forming, punching, and shearing machines
• Meatpacking or meat processing (including the use of power- driven meat-slicing machines)
• Working with power-driven bakery machines
• Working with power-driven paper product machines, including scrap-paper balers and paper-box compactors
• Manufacturing brick, tile, and related products
• Working with power-driven circular saws, band saws, and guillotine shears
• Wrecking, demolition, and ship-breaking operations
• Roofing operations and all work on or about a roof
• Excavation operations

If want to employ your child in one of the above hazardous occupations, check the exemptions that might apply, by going to http://www.dol.gov/elaws/esa/flsa/cl/exemptions.asp.

Count on Extra Scrutiny

The courts note that wage and salary payments from a father or mother to one or more of his or her children require careful scrutiny.¹⁶

It’s a family relationship. The court needs to take a close look to make sure there is both¹⁷

• a bona fide employer-employee relationship, and
• a performance of services for the business.

Planning tip. Make sure that you pay a reasonable wage based on a time sheet submitted in a timely manner.

Forget Food and Lodging

In the right circumstances, it is possible to build tax deductions for food and lodging furnished to an employee. That’s not going to happen with your minor- age children, because as the parent you are legally liable for support and maintenance of your minor-age children.¹⁸

Build Audit-Proof Support

1. Get an employer ID. When you become an employer, you need an employer ID number. You can apply for your employer ID number online, by fax, or by snail mail (no telephone applications for United States applicants). When you apply online, the IRS will assign a number immediately.

2. Require a time sheet. The handwritten time sheet is excellent proof. Your child should complete the time sheet daily and turn it in weekly.

We have a time sheet that you can use. To get the time sheet, click either PDF or Excelformat.

You should have your child complete a time sheet to help prove that he or she did the work. Vernon E. Martens hired his two sons and two daughters, but he lost about 80 percent of the payroll deductions he claimed for hiring his four children, because he did not require time sheets.¹⁹

3. Document the pay scale. If you are paying your child minimum wage, you don’t have to worry about documentation of the pay rate. But you probably want to pay at a higher rate. This requires proof that the rate you are paying is a reasonable rate for this employment.

Let’s say you used to pay a website developer $75 an hour to set up your web pages. Let’ssay your son can do this work, but it takes him about twice as long to get the work in place. You have to think that an hourly rate of less than

$37.50 is reasonable for the son. The key here is documentation of how you arrived at your reasonable rate of pay.

4. Pay with a W-2 payroll check. Always pay wages by W-2 payroll check. The W-2 wage is what exempts the under-age-18 child working for a parent from payroll taxes.

Also, you need to establish a clear audit trail from your business checkbook to your child’s bank account. Remember, when you pay your child, this is now your child’s money.

If you use a payroll service, make sure to explain to the service that your child is exempt from payroll taxes, and then make sure to check the payroll. Often, payroll servicesmistakenly take out FICA and Medicare on the child when they should not. (Note: In a few states, the state does not exempt the parent’s proprietorship or partnership business from unemployment taxes on the child.)

5. Complete the federal and state payroll forms. Your federal paperwork includes the forms below. To obtain one of the forms, enter this address in your browser or click this link: http://www.irs.gov/app/picklist/list/formsInstructions.html.

IRS Form W-4. Your employee-child uses this form to tell you, the employer-parent, howmany exemptions and allowances he or she claims and whether he or she is exempt from withholding taxes.

IRS Form W-2. If you paid your child more than $600 in wages, you must provide your child with a copy of IRS Form W-2. You also must file IRS Form W-3 and copies of the W-2s with the Social Security Administration.

IRS Form 941. You report withholding, FICA, and Medicare on this form. Remember, wages paid by the mother or father to the child are exempt from FICA and Medicare. That’s nice, but even when no taxes are due, this form is due. Your dealings with the IRS are easiest if you fileeach quarter, even if you are eligible for seasonal filing. The IRS computers like to see Form 941 every quarter.

IRS Form 940. The wages you pay your under-age-21 child are exempt from unemployment taxes. Even so, you must file IRS Form 940. If your child is your only employee, you enter the amounts paid to your child as both (1) gross pay and (2) exempt pay, making a net payment of zero subject to federal unemployment tax.

Do the Paperwork or End Up Like This Lawyer Mom

Failing to take the documentation steps can blow up on a parent. Lisa Fisher learned this the hard way.

Lisa practiced law as a sole proprietor and sometimes brought her three children (all under age nine) into her office. The kids usually worked at the office two or three days a week for about two hours each day. They shredded confidential and other paper, sent out mail, answered phones, and performed other services connected to their mom’s law practice.

Lisa claimed deductions in the three years before the court of $10,435,

$10,313, and $8,022 for the wages she paid to her children. The IRS disallowed the deductions, and Lisa, lawyer that she was, took her case to court.²⁰

Bad call on her part—not only did Lisa lose out on the wage deductions, but she also got dinged with negligence penalties.

Lisa made three big mistakes that cost her the claimed deductions:

1. She didn’t issue her children W-2 forms.

2. She didn’t keep payroll records of any payments to her children.

3. She didn’t have any documentary evidence (for example, canceled checks for payments to the children, time sheets showing hours worked, or the rate of pay per hour).

Without such evidence, the court came up with its own amount for the deductions—a meager $250 for each child for each year. Not quite the generous deductions Lisa had hoped for.

Worse, she ended up on the hook for penalties because her resulting understatement of taxes exceeded $5,000 for each year. Even if the understatement was less, the court said, she had to pay the penalties because her failure to keep adequate books and records related to the kids’ pay was negligent.

Takeaways

If your children do not pay income taxes as you read this, they are excellent candidates as employees for your business regardless of business form:

1. The children pay zero taxes on earnings up to the $6,350 standard deduction amount.

2. They can use the traditional IRA to avoid taxes on $5,500, giving them a total of $11,850 on which they can avoid taxes.

3. They can use the 10 percent tax bracket, standard deduction, and traditional IRA so as to pay itty-bitty taxes on earnings up to $21,175.

To get this right, you need to pay the child on a W-2, have the child keep a time sheet, and create proof of a reasonable wage.

The IRS has approved employing children as young as seven years old.

If the children working for a parent are under age 18, both the children and the parent or parents are exempt from payroll taxes. In these cases, the parent operates a Schedule C business or both parents are the sole owners of a partnership.

Corporations are not parents. They do not qualify for this exemption from payroll taxes. Even so, corporate hires of the owner’s children usually produce good tax benefits.

All business owners can achieve tax benefits by hiring their children, regardless of the type of business entity. But parents who are Schedule C owners or in spousal partnerships achieve more benefit because neither they nor their under-age-18 children are subject to payroll taxes.

If you want my help, please call us at (818) 600-4494