Becoming a successful small business owner is one of the hardest things that a person can do. For decades, the chances of a small business with employees making it past the five-year mark has been remarkably consistent, at roughly a 50/50 proposition. And at 10 years, the numbers are even worse, with only around a third of the original businesses still hanging on.
With the chances of success being so statistically low, one has to ask themselves, “Why are there still so many people willing to take on the long odds?” And while the answers are surely varied, one of the most common reasons individuals seek to become business owners is that they are able to have more control over decisions. Those decisions include, among others, what types of solutions the business will offer, how it will service its clients/customers, who the business will use for vendors, and who the business will hire (and fire).
And as the IRS’s own website itself says: “One of the advantages of operating your own business is hiring family members”. That family member can be a spouse, sibling, parent, or even a child. In fact, while hiring a child may not seem like a top-of-mind move for many businesses owners, if you play by the rules, there can be a surprisingly broad array of tax (and other) benefits to doing so!
In fact, with the Tax Cuts and Jobs Act increasing the Standard Deduction up to $12,200 (in 2019), children employed in a family business can earn that much in income and enjoy a 0%(!) tax rate on their income (at least for Federal tax purposes), all without facing the Kiddie Tax (which only applies to unearned income). In addition, many states will also permit children employed in the business to avoid unemployment (FUTA) taxes, and children working for their parents’ sole proprietorship, partnership, or LLC may also avoid employment (FICA) taxes as well (which can be a material tax savings for many families, and especially those with high-income parental business owners). Furthermore, employing a child in the business also creates earned income that can qualify the child to make a Roth IRA contribution, and/or qualify the child for other employee benefits.
The caveat, though, is that employing a child in the business still requires that he/she do bona fide (age-appropriate) work in the business (i.e., a “real” job), for a “reasonable” (and not excessive for tax purposes) wage. The work must also comply with both Federal Fair Labor Standards Act (FLSA) rules (which fortunately are fairly flexible for parents employing their children in their own wholly-parental-owned business), and state child labor laws as well.
(Michael’s Note: This post was written by Jeffrey Levine, CPA/PFS, CFP®, CWS®, MSA. Jeff is the Director of Advisor Education for Kitces.com, CEO and Director of Financial Planning for BluePrint Wealth Alliance (where he drives the firm’s vision of delivering a unique, modern approach to the financial, tax, and estate planning), and is the Lead Creator and Content Expert for Savvy IRA Planning®, offered through Horsesmouth. Jeff is a recipient of the Standing Ovation award, presented by the AICPA Financial Planning Division, and was named to the 2017 class of 40 Under 40 by InvestmentNews. Previously, Jeffrey served as Ed Slott and Company’s Chief Retirement Strategist, where his ability to simplify the complex laws that govern individual retirement accounts, combined with his unique blend of humor and tax planning, was first recognized. Jeffrey continues to be an active speaker, traveling the country each year to educate thousands of Financial Advisors, CPAs, Attorneys, and consumers on retirement, tax, and estate planning strategies. You can follow Jeff on Twitter @CPAPlanner and via his personal website.
The Fair Labor Standards Act (FLSA) And Child Labor Laws
Although labor laws have evolved quite a bit over the past 80 years (via legislation such as the Equal Pay Act of 1963 and the Age Discrimination in Employment Act of 1967), the Fair Labor Standards Act of 1938 continues to play a major role in workplace governance. The law, which created employment guidelines, such as the minimum wage ($0.25/hour in 1938!) and overtime pay, also placed significant restrictions on child labor, largely in response to the dangerous, and sometimes deadly conditions, in which children were employed in cotton mills, factories and other businesses at the time.
General Federal Child Labor Rules
Under the Fair Labor Standards Act (FLSA), there are essentially four different tiers for labor standards covering non-farm employment for children. They break down as follows:
- Children under the age of 14,
- Children 14 and 15,
- Children 16 and 17, and
- Children 18 and older
The first tier of labor standards for children covers those who are under the age of 14. In general, such children are not allowed to perform any non-farm work for any number of hours. Children delivering newspapers, babysitting on a casual basis, working as an actor or model, or employed as a homeworker making evergreen – and only evergreen – wreaths (someone in Congress must have had a serious “axe to grind” against deciduous trees, huh?) are exempt from these rules, however, and may generally work at any age (at least from a Federal labor law perspective).
The second tier of child labor laws covers children who are 14 and 15 years old. Such children may be employed, but have a substantial amount of restrictions placed upon that employment, including the numbers of hours they can work per day and per week (which varies depending upon whether school is in session), when those hours can be worked (which varies depending upon the time of year), and what sorts of jobs they can have.
By the time children are 16, they can generally work as many hours as they wish and at whatever time(s) they like. In general, the only restrictions to which they are subject are those that prevent them from working jobs that have been deemed “hazardous” by the Department of Labor, such as jobs that involve “exposure to radioactive substances and ionizing radiation”, “coal mining” or “working in wrecking , demolition, and ship-breaking operations”.
And finally, once a child reaches the age of 18, there are no longer any restrictions on their employment. They are considered full adults in the eyes of the law, and may work whatever hours they want (subject to “normal” labor restrictions), whenever they want, and doing whatever they want.
Exemption To FLSA Child Labor Laws For The Employment Of A Child In A Parent-Owned Business
Now if all of that sounds utterly complicated, but you’ve been considering hiring one or more of your own young children to work with you in your business, here’s the good news… unless you own a hazardous business, it likely doesn’t matter!
In addition to more narrow exemptions to the general rules, such as those that allow certain student-learners to engage in certain otherwise-prohibited work, there is a broad exemption to the child labors laws for young children employed in businesses owned solely owned by their parents. Such children may, at any age, typically work an unrestricted number of hours, at any time of day or night, so long as the parent-owned business is not involved in mining, manufacturing, or one of the aforementioned occupations designated as hazardous by the Department of Labor.
Notably (and despite a substantial number of generally credible, well-respected websites saying otherwise), this exemption is available regardless of the entity structure of the parents’ business, so long as the business is wholly owned by the parents. In fact, as stated in Section e00(a)(2) of Chapter 33: Child Labor, of the Department of Labor’s Wage and Hour Division’s Field handbook:
The exemption applies only when the parent is the sole employer of the minor. If the parent is a partner in a partnership or an officer of a corporation, the parental exemption does not apply unless the parents are the only members of the partnership or the sole owners of the corporation.
Thus, a sole proprietorship where one parent is the business owner clearly qualifies for the exemption… but so does a partnership where both parents are the only partners, and corporations as long as one or both parents are the only shareholders.
State And Local Laws Governing Child Labor
The Fair Labor Standards Act is a Federal law that “only” applies to situations in which a business is engaged in some level of interstate commerce. Today however, thanks to the internet, the phone, and even mail service, nearly all businesses have some level of interstate commerce that would leave them subject to the Fair Labor Standards Act.
In addition to Federal rules, however, business owners wishing to employ their minor children in their business must also be cognizant of any State or local laws that can be more restrictive than the Federal Fair Labor Standards Act. In situations where State law is the more restrictive of the two, State law must be followed.
Some states, for instance, have minimum age requirements for children working in a parent’s business that are different than the Federal rules (no limit), while others place additional restrictions on the number of hours that a minor can work, or when those hours can be worked. And while the Federal law does not require any sort of verification prior to employment, the majority of states require certain minors to be obtain “Employment Certificates” – also known as “Working Papers” – prior to employment. Such requirements are often necessary even when that employment is by a parent-owned business.
Thus, prior to employing any minor, including a one’s own child, business owners should be sure that they are aware of all pertinent local law. Otherwise, any tax or financial benefits of hiring your child could easily be outweighed by penalties and/or prolonged audits and inspections by the Federal and or State Departments of Labor!
Shifting Taxable Income To A Child Employed In The Family Business
In addition to non-financial benefits, such as the ability to spend more time together (note: child may not find this to be as much of a benefit as the parent!), there are several tax benefits that may be available when parents hire their minor children to work in the family business. Together, these benefits can produce significant tax savings in the right situations.
The biggest, and most obvious benefit to hiring a minor child in the family business, is the ability to shift income from what is presumably the parents’ higher income tax rates, to the child’s (presumably lower) rates. And thanks to the Tax Cuts and Jobs Act’s roughly “doubling” of the standard deduction, children are able to have more income than ever taxed at a 0% rate!
In 2019, the standard deduction for individual filers – applicable to most minor children – is $12,200. Thus, minor children can earn up to $12,200 from employment, and pay no Federal income taxes. And while state income taxes may apply to those amounts in certain situations, if the child is at a lower Federal rate than their parents, they will also generally be at an equal or lower state income tax rate, too (making the potential income tax savings even greater)! In situations where a business-owning parent is in a relatively high income tax bracket, shifting income to the minor’s 0% Federal and also-lower state tax rate can produce quite a bit of family tax savings… especially when there are multiple children to employ!
And notably, the so-called “Kiddie Tax” is of minimal concern here, as the Kiddie Tax is a tax levied on “unearned income”, such as interest, dividends, capital gains and distributions from inherited IRAs, 401(k)s, and other retirement accounts. In contrast, income generated from employment – including employment by a parent – is earned income. Thus, the Kiddie Tax does not apply to such amounts, and the full amount of the Standard Deduction (and availability of lower tax brackets) is permitted.
Example #1: Kent is the owner of Kent’s Kandy, a successful local candy store. He is currently in the 35% tax bracket, and has three children, ages 14, 15 and 17. If Kent were to hire each of his children to work for the year, and paid them each $12,200, the deductions would reduce his 2019 taxable income by $36,600 ($12,200 x 3 = $36,600), lowering his own taxes by $12,810 ($36,600 x 35% = $12,810). That tax savings alone more than pays for the salary of one of Kent’s children!
To make things even “sweeter” for Kent and family, if we assume that Kent’s children have no other income, the entire $12,200 salary paid to each child is 100% Federal-income-tax-free! Which means it’s a true family tax savings of the same $12,810.
From Kent’s perspective, if he were going to “give” his kids allowance or spending money anyway, this is a far more tax efficient way of doing it (and it might teach them some life skills at the same time)!
For business owners at or near the new qualified business income (QBI) deduction phaseouts, the tax savings can be even more significant. For example, the payment of a salary to a minor can help reduce a parent-business-owner’s taxable income so they can enjoy a larger QBI deduction.
In addition, the wages paid to a minor child count as wages paid for the wages or wages-and-depreciable-property tests for the QBI deduction. Which means those kids’ wages can slow down the phaseout of the QBI deduction for owners of Specified Service Trades or Businesses (SSTBs) with income within the phaseout range. It can also help to preserve up to the full QBI deduction for non-SSTB business owners with incomes within or above their applicable phaseout range.
Cumulatively, the reduction of the owner’s income via the payment of salary to a minor child, plus the potential increase in the owner’s QBI deduction as a result of such a decision, can save a business owner with the “right” set of facts and circumstances nearly 50 cents of every dollar paid to their child in Federal taxes. Getting Uncle Sam to split an “allowance” with you isn’t exactly a bad gig!
Avoid Employment Taxes On A Child’s Salary
In addition to the “regular” income tax savings that may be available when paying a salary to a minor child, the Federal tax law also offers potential savings on employment taxes as well. Specifically, sole proprietorships, single-member LLCs, and partnerships (but not corporations, including S corporations) where both parents are the only partners/owners of the business are not required to pay Social Security or Medicare (FICA) taxes when employing a minor (under 18 years of age) child. (Though notably, that also means the child will not accrue Social Security benefits based on those earnings either, nor even start accruing any quarters of coverage to qualify for Social Security and Medicare benefits in the future.)
Furthermore, sole proprietorships, single-member LLCs, and partnerships where both parents are the only partners of the business are not responsible for Federal unemployment (FUTA) taxes on children under 21. Such businesses, however, may still owe state unemployment taxes.
In addition, it’s important to note that even if a child-employee’s wages are not subject to FICA and/or FUTA, those wages are still subject to Federal withholdings (unless the child is otherwise exempt). Thus, the child should still receive a W-2 from the business. And they may have to file a Federal tax return to get a refund of any excess amounts withheld (which would be all of the amounts withheld if their employment income is fully offset by the child’s Standard Deduction).
Children’s Employment Tax Savings For Parents With Corporations
Given that corporations – including S corporations – are not eligible for the special employment tax breaks on FICA and FUTA, even when a child’s parents are the sole shareholders of the corporation… parents in this situation have several options to consider:
Do nothing and hire the child via the corporation – One option for a parent looking to hire their child to work for their wholly-owned (potentially with the other parent) corporation is to simply accept the restrictions and hire the child anyway. Sure, it’s nice to save on employment taxes, but the combined Social Security and Medicare taxes (15.3%) that would be owed on a child’s salary, plus the federal unemployment tax (6% on the first $7,000 of wages) would still “only” equal about 19% on a $12,200 salary. And ostensibly at least some of the Medicare (or Social Security) taxes would have been paid by the parents if the income was allocated to them anyway. Thus, even with some FICA and FUTA tax obligations, there would still be a tax savings to employing the child in the business, especially for higher-income business owner parents.
Change entity structure – Another possibility for a parent in such a situation is to “scrap” the S corporation and turn the business into a sole proprietorship, single-member LLC, or partnership with the other parent. It’s highly unlikely that such a change would be beneficial solely for the purpose of escaping employment taxes on a child’s – or even multiple children’s – salary. However, given the many changes created by the Tax Cuts and Jobs Act, including the potential advantages of non-corporate entity structures for certain business owners with respect to the qualified business income tax deduction, a change in entity structure may make sense anyway. The additional employment tax savings of hiring a minor child would just be a cherry on the top!
Create another business and employ children there – Another, more aggressive approach to saving on employment taxes for parents looking to hire their child to work for their wholly-owned (potentially with the other parent) corporation is to establish a separate sole proprietorship (or single member LLC or partnership where both parents are the only partners) family management company.
The separate employment-tax-savings-eligible family management company would then contract with the S corporation to provide services, and the family management company would the hire the children to provide those services. For example, the family management company might other services like answering the phones, computer support, or social media marketing.
Parents who wish to go this route, however, should not do so “willy-nilly”. There should be little doubt that, of all the possibilities discussed here, this is the most aggressive. And while, in theory, there should be nothing preventing a parent from engaging in such a series of transactions, in the event of an audit, count on the IRS digging deeper and asking questions.
Thus, for those who choose to utilize this “work-around” to avoid employment taxes on a minor, keeping good records is an absolute must. For instance, keep copies of the contract and/or related documentation between the “regular” S corporation business and the newly formed family management company. Any “outside” business to the family management company (i.e. a small social media marketing engagement with another unrelated company) would likely also go a long way to having the IRS respect the entity.
And of course, even in a best-case scenario, the family management company would be the employer of the children, meaning that the family management company would have to run payroll, issue the W-2s, and file a tax return (likely a Schedule C). This extra work may negate all or part of the benefits of establishment for some business owners.
Other Benefits Of Employing Children In A Parent’s Small Business
While families can often enjoy a material amount of income tax savings (and potentially FICA and FUTA tax savings as well) by employing and paying children in the family business, an immediate income tax savings is not the only benefit of the strategy.
Children’s Salaries Create Earned Income That Can Be Used To Fund Roth IRAs
Future tax rates are reasonably uncertain. But one thing that you can say about a child’s future tax rate with a high degree of confidence is that if the child’s tax rate today is 0% – thanks to, say, the “new” larger standard deduction – their future tax rate won’t be any lower (and in all likelihood, will be significantly higher). Thus, with respect to long-term tax planning, “buying” today’s low tax rate via a Roth IRA contribution usually makes a great deal of sense.
In order to make a Roth IRA contribution, there are only two requirements: 1) an individual must be below their applicable income threshold (phased out between $122,000 and $137,000 for single filers in 2019); and 2) they must have earned income. Thus, unless a minor child has a substantial amount of other income – in which case income shifting via employment may no longer make sense – they will be eligible to make a 2019 Roth IRA contribution, up to the lessor of $6,000 or their actual earnings.
Thanks to the power of long-term compounded growth, these early contributions could have material impact on the child’s retirement savings. For instance, by “just” contributing the maximum $6,000 contribution to the child’s Roth IRA each year from 15 through 17 (3 years of contributions), by the time the child reaches 65 he/she will have accumulated nearly $500,000 ($496,295.17) of tax-free retirement money, assuming a 7% annual rate of return.
It’s also notable that with respect to Roth IRA contributions… while the child does need to have their own compensation to support the contribution, the child doesn’t actually have to be the one to make the contribution. Thus, should they desire to do so, a parent-employer can allow their child to keep all of their earnings, while separately contributing the parents’ own money into the child’s Roth IRA. (Presuming the parent has not already capped out his/her annual gift limit to the child.)
A Working Child May Be Eligible For Other Employee Benefits
If your child is an employee of your business, they are generally entitled to the same employee benefits as other employees. That could include benefits such as HSAs, FSAs, or being able to contribute to (or receive contributions on their behalf into) other retirement plans as well. If you plan to hire your child, it’s important to understand these additional opportunities… but also additional costs (if there wasn’t otherwise a desire to include them and pay for their employee benefits), and to plan accordingly.
For example, SEP IRAs are a common retirement plan for small businesses. If, in addition to hiring your child you also wanted to include them when making SEP contributions, you would probably want to set up your plan so that younger workers are allowed to participate. On the other hand, if you wanted to exclude your children from receiving SEP contributions under the plan, leaving the typical defaults in place make sense (typically preventing employees from participating if they are under 21). .
In all cases, though, it’s important to remember that whatever rules you set for your retirement plan or other employee benefits, they apply across the board. So, for instance, if you make the retirement plan participation age lower and hire your son’s friend to work in the business too, you’ll likely get “stuck” making retirement contributions for the friend too!
Cautions And Contradictions When Hiring Minor Children In The Family Business
Clearly, there are ample benefits to hiring one’s child to work in their business. But like most financial decisions business owners face, before moving forward, there are important things to consider that may make the decision less appealing than it would seem at first glance.
You Must Hire Your Child For A “Real” Job
If you’re thinking about hiring your minor child to work in your business, one of the most important things you must consider is that you are actually respecting the basic framework around and employer-employee relationship. You can’t, for instance, just “throw you child onto payroll” in order to save some taxes, if they don’t actually do something in the business. That’s not going to fly.
Rather, just like any other employee, you should be hiring your child to provide bona fide services to your business. It’s highly unlikely that a 5-year-old is going to be keeping your books for you, but there are certain jobs that even young workers can typically handle. Common work-related activities minor can perform include cleaning, filing, answering the phones, and other clerical work. Or even being a “child model” by using their images in the business’ marketing materials.
In addition, many children today are far more versed in computers, information technology, and social media than their parents. Thus, such “jobs” can also be common reasons to employ minor children in your business.
In all cases, though, be certain that the work being assigned is not only age-appropriate to the child themselves, but is age-appropriate to the relevant Federal and state child labor laws.
You Must Pay The Child A Reasonable Wage
When tax professionals discuss “reasonable” wages, it’s typically in the context of paying wages that are high enough. The reality, though, is that reasonable has two boundaries. There is a lower boundary, below which wages are not significant enough to be considered “reasonable”, and there is also an upper boundary, above which wages would also fail to be “reasonable”. It’s this upper boundary that is often the issue when it comes to paying minor children.
Suppose, for instance, that you wanted to hire your child on a part-time basis for a salary of $1,016.67 per month (to get to the $12,200 standard deduction amount for 2019). If your child only came in and worked 5 hours per week, for a total of 20 hours per month, that would equate to over a $50 per hour rate.
If their role in the business is clerical in nature, and mainly consists of answering phones, making photocopies, or engaging in similar activities, chances are the IRS would find that $50 per hour rate to be unreasonable… especially if you have other, higher-skill labor on the books at a lower hourly rate! If, on the other hand, your child is doing more higher-level activities, such as social media marketing, a $50 per hour rate may not be unreasonable at all.
You should also try to pay your child cash (or at least, electronically via payroll into an online bank account), whenever possible, to minimize concerns over conflated work with parental responsibility. Although Federal laws allow salaries to be paid in property (e.g., an exchange of goods for services), it can be tempting for some to push the boundaries too far. For instance, in July 2014, Patricia Diane Ross – of all things, a paid tax preparer – was denied by the Tax Court for deductions related to having paid her children in (largely) pizza, despite keeping decent records and receipts.
Keeping track of a child employee’s hours and activities is good practice though, and should be done in all situations anyway. And if you can get documentation of hourly rates for similar roles at other unrelated companies, that are in line with what you’re paying, well then you’re about as good as you can get on this matter!
Be Mindful Of Any Financial Aid Impact
In the United States, the most common and important form when it comes to financial aid for higher-education is the Free Application for Federal Student Aid (FAFSA) form.
In general, 50% of a student’s income is counted toward the expected family contribution (EFC), whereas “only” up to 47% of a parent’s income is allocated towards the same formula. Students are, however, allowed to “protect” nearly $6,700 of income with respect to the FAFSA calculation. Thus, the shifting of income from parent-to-student may actually still produce a net-positive FAFSA result, depending upon both the student’s and parent’s other income for the year. Which is especially relevant once the child is a sophomore or older, where their current tax year will be used for future financial aid status when they matriculate to college under the “prior-prior year” FAFSA rules.
Could You Jeopardize Dependency Status?
The Tax Cuts and Jobs Act of 2017 eliminated the personal exemption deduction for dependents beginning in 2018. Erroneously, many people now believe that claiming a child as a dependent is irrelevant for tax purposes. That’s far from the truth, and in some way, claiming you child as a dependent is more important today than ever before.
Consider, for instance, the expanded Child Tax Credit. For years prior to 2018, the credit was “only” a maximum of $1,000 per child. In addition, many upper-middle-class families lost out on the deduction because it started to be phased out at $110,000 of modified adjusted gross income (MAGI). In 2018 under TCJA, however, the maximum credit was increased to $2,000 per eligible child, and the income limit for phaseout of the credit for a married couple was increased to $400,000!
Thus, far more parents will claim far bigger Child Tax Credits for 2018 (and through 2025 under current law) than they ever have before. But… and this is a big but… in order to claim the Child Tax Credit, the child for whom you are trying to claim the credit must be a dependent! The Child Tax Credit is far from being alone in this regard. Indeed, there are many tax benefits that are available for children, but in general, those benefits are only applicable if that child is a dependent.
So where does hiring your child potentially impact their dependency? Simply put, one of the key tests to determine dependency is the “Support Test”, which says that in order to claim a child as your dependent, you must provide at least half of their support for the year.
In all likelihood, a salary of $12,200 won’t allow a child to provide more than half of their own support, including housing, for the year. However, if the child also has another job and lives in a reasonably low-cost area, it is definitely something that should be factored in to the decision process.
Ultimately, being a business owner can be one of the most rewarding things a person can do in life. Unfortunately, though, creating and operating a business can be a time-consuming process that can pull an entrepreneur away from the home and family more than they’d like.
But with that said, being a business owner also allows for a great deal of control over one’s working environment, including with whom they share that environment. Thus, for some business owners, hiring a child can present a double-whammy benefit. It can not only allow the business owner to spend more time with that child but, at the same time, it can allow the business owner to take advantage of a variety of tax and financial benefits to keep more of their hard-earned money in the family coffers.