Putting your children on payroll: when it legitimately lowers the family's taxes

Legal, effective and full of conditions

Yes, hiring your children in your business is legal, and for many self-employed families it is one of the most effective ways to lower the household's tax bill. The savings come from shifting income from the parent's tax rate to the child's, and, in some business structures, from exemptions the IRS provides for children employed by their parents. It only works if the child does real work, is paid a reasonable wage for it, and the arrangement is documented and run through payroll like any other job.

Legitimately employing family members is a central part of our Optima Program at Hockaday CPA, a tax-planning service we built for family-owned and self-employed businesses such as real estate agents, insurance brokers, landscapers and sales professionals. I have seen this strategy save families real money, and I have seen it fall apart when someone treated it as a paper exercise. This guide explains how the rules work, what makes it hold up and where people go wrong. It is general information; talk to a licensed CPA before setting it up for your family.

Where the savings actually come from

There are two sources of savings. The first is income shifting. When the business pays your child a wage for real work, that wage is a deductible business expense, which reduces the profit taxed at your rate. The child reports the wage as their own income, and because a child's earnings are generally sheltered by their own standard deduction up to a point, a modest wage may owe little or no federal income tax.

The second source is payroll tax, and it depends entirely on how your business is organized. If you are self-employed, every dollar of profit can be subject to self-employment tax in addition to income tax. Moving a portion of that profit to a child's wage can remove it from both, if the structure qualifies for the exemptions described below. That combination is why the strategy is most powerful for sole proprietors and parent-owned partnerships.

Timing matters as much as structure. Wages count in the year they are actually paid for work actually done, which means this strategy cannot be created in March for the year that just ended. Families who decide in April to try it are really deciding for the current year, and the sooner payroll starts, the more of the year it covers. That is one reason I encourage self-employed clients to have the planning conversation early rather than waiting until the return is being prepared.

The IRS rules depend on how your business is set up

The IRS spells out how family employment is taxed, and the business structure changes the answer. According to the IRS, when a child works for a parent's sole proprietorship, or for a partnership in which every partner is a parent of the child, wages paid to a child under 18 are not subject to Social Security and Medicare taxes, and wages paid to a child under 21 are not subject to federal unemployment tax. Income tax withholding rules still apply regardless of age, so the child completes a W-4 like any employee.

The picture is different for a corporation. The IRS states that wages paid by a corporation, by a partnership unless every partner is a parent of the child, or by an estate are subject to income tax withholding, Social Security, Medicare and federal unemployment tax regardless of the child's age. That does not make hiring your children pointless in an S corporation, since the income shifting may still help, but the payroll tax savings largely disappear. This is one reason entity choice and family employment should be considered together.

• Sole proprietorship, or a partnership owned only by the child's parents: no Social Security or Medicare on wages to a child under 18; no federal unemployment tax under 21
• Corporation, including an S corporation: all payroll taxes apply regardless of age
• Partnership with a non-parent partner, or an estate: all payroll taxes apply regardless of age
• Income tax withholding rules apply in every structure

One family's numbers, from our own case study

On our Optima Program page we publish a case study of a real estate salesperson with two children, ages 8 and 12. Each child was paid for genuine tasks in the business: clerical work, sign placement, help at open houses and market research. In that example, the firm calculated total savings of $6,287 for the year, from shifting income out of the parent's combined income and self-employment tax rate and from how the family handled the children's medical expenses. A second case study on the same page, for a direct marketing business with three children, shows total taxes falling by more than $4,000.

Those figures come from specific families in specific years, and tax rates and rules change. The firm states that Optima can save some qualifying taxpayers $2,000 to $20,000 or more per year, and the key word is qualifying. Your result depends on your profit, your structure, your children's ages and the work they can genuinely do.

Wondering whether your family qualifies?

If you are self-employed or own a family business and your children are old enough to help, this is worth a conversation before the year ends, because wages have to be paid during the year to count. Our first consultation is free. Bring last year's return and a rough idea of what your children could do, and we can tell you whether the numbers make sense for your family.

What makes the arrangement hold up

In my experience, every arrangement that survives scrutiny shares the same features. The work is real, appropriate for the child's age and actually needed by the business. The pay is reasonable for that work, roughly what you would pay someone else to do it. And the paperwork looks like any other employment relationship.

That last point is where most families fall short. A deduction for wages you cannot document is a deduction you may lose. Our guide on which tax records to keep and for how long explains the support the IRS expects for business expenses generally, and wages to family members deserve at least the same care.

• A written description of the child's duties
• Time records showing dates, hours and tasks
• A wage set at a reasonable rate for the work, not for the tax result
• Payment by check or transfer into an account in the child's name
• A W-4, payroll records and a W-2 at year end
• Work that matches the child's age: a young child sorting mail is plausible; a young child doing market analysis is not

Where families get it wrong

The most common mistake is paying a child for work that did not happen, or paying a large round number at year end to hit a target. That is not tax planning; it is a deduction waiting to be disallowed. The second is paying the wage and then quietly using the money for household expenses the parents would pay anyway. The money should belong to the child, whether it goes to savings, a college fund or the child's own expenses. In one of the case studies on our Optima page, the children used their pay to fund college accounts.

The third mistake is ignoring structure. Owners of S corporations sometimes assume the payroll tax exemption applies to them, and it does not. The fourth is skipping payroll formalities because it is family. The fifth is forgetting that child labor rules still govern what kind of work a child may do. Each of these is avoidable with planning up front.

Fitting it into the family's bigger plan

Family employment works best as part of a broader plan rather than a standalone trick. It interacts with your estimated payments, since lowering your profit changes what you owe each quarter; our guide on quarterly estimated taxes explains how those are sized. It also interacts with your choice of entity, your retirement contributions and the way you track business expenses.

Many parents also like the non-tax side: children learn how a business runs, see what work is worth and start building savings of their own. If you are thinking about the family's protection and savings more broadly, a financial advisor can help with that side; our colleague's guide on putting a working family's protection and savings in order is a useful companion. And if you are unsure whether your situation is complex enough to need a CPA at all, our guide on signs your return has outgrown software can help you decide.

How we set it up with you

When a family comes to us through the Optima Program, we start with the business: its structure, its profit and the work that genuinely needs doing. We look at the children's ages and what they can realistically handle, set a reasonable wage, and help put the payroll, time records and documentation in place. Then we model the result so you can see what the strategy is worth before committing, and we fold it into your estimated payments and year-end planning.

Our Frisco office works with self-employed people and family-owned businesses across Collin County and the Dallas area, and we also run payroll and QuickBooks bookkeeping, so the arrangement can be handled in one place. Call or use the form on our website to schedule a free consultation.

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