Understanding the Benefits and Compliance Requirements
By James C. Yochum, CPA, Corridor Consulting
In today’s competitive business environment, finding tax-efficient strategies is crucial for closely-held businesses. One such strategy is employing your child in your business. This approach not only aids in income shifting but also opens doors to significant tax savings and financial planning opportunities for your child.
Income-Shifting and Tax Savings
When you hire your child in your business, it’s not just about getting help; it’s a strategic move. This income-shifting strategy allows your business to deduct the wages paid, while your child reports this income. In many cases, the child will incur lower taxes or none, compared to the higher rates you might face. This not only results in tax savings but also enables your child to contribute to a Roth IRA, benefiting from tax-free compound growth over time.
Tax Exemptions for Young Employees
The IRS has specific provisions for employing children in family businesses. Under §3121(b)(3)(A), if your child is under 18 and works in your sole proprietorship or a family partnership, neither you nor your child must pay Social Security and Medicare taxes on their wages. Additionally, under §3306(c)(5), if they are under 21, your business is exempt from paying unemployment taxes on their wages. However, this doesn’t apply if your business is a corporation; in that case, both payroll and income taxes apply.
Avoiding IRS Red Flags
The IRS closely scrutinizes payments to relatives. For instance, in Holtz v. Comm., payments to children were considered non-deductible personal expenses, not business expenses. To avoid this, you must treat your child as a bona fide employee, fulfilling all standard employer obligations like tax filings, regular payment for services, and maintaining employment records.
In Ross v. Comm., the Tax Court highlighted several “red flags” that could lead to the disqualification of such deductions. These include not paying employment taxes, paying fixed amounts irrelevant of work done, and poor record-keeping.
Determining Reasonable Wages
A crucial aspect of this strategy is to pay your child a reasonable wage, comparable to what you would pay an unrelated employee for similar work. In Denman v. Comm., it was established that specific compensation must be reasonable for the services performed. Paying a wage equal to their standard deduction, for example, could be seen as a tax avoidance scheme.
Compliance with Wage Reporting
If you pay your child over $600 annually, you’re required to file Form W-2. This not only meets legal requirements but also supports Roth IRA contributions and provides documentation in case of IRS scrutiny. Failing to file Form W-2 can lead to significant penalties.
Tax Forms for Employers
Forms 941 and 940 are essential for businesses employing their children. Form 941 relates to wages subject to federal income tax withholding, and Form 940 deals with unemployment taxes. Although a child’s wages may be exempt from certain taxes, compliance with these forms is still required.
Weighing the Compliance Costs
While there are clear tax benefits to employing your child, it’s important to consider the compliance costs, especially if your child is your only employee. These costs should be factored into your decision-making process.
Conclusion
Employing your child in your business can be a win-win situation, offering both tax savings and valuable work experience for your child. However, it’s crucial to navigate this strategy with a full understanding of the tax laws and compliance requirements to maximize benefits and avoid potential pitfalls. As always, consult with your tax advisor to tailor this strategy to your specific business and family circumstances.
This blog post is intended for informational purposes only and should not be construed as legal or tax advice. Each business situation is unique, and tax laws are subject to change. Please consult a tax professional for advice on your specific situation.