Hiring your children to work in the family business is a smart move about taxes – for you and them

You have recently been self-employed and your children are out of school during the summer. Hmmm. Do you have one or more young people who could do useful work for your business? If so, hiring your child – or several of your children – can provide some nice tax benefits. As children drop out of school and are likely to be fully accessible in the next few months, this is a timely story. Forget about those swimming and tennis lessons you may have been thinking about. Get the damn kids to work. They need to learn about capitalism, and the sooner the better. Here’s what you need to know about the tax consequences.

Tax benefits for your child

You run your business as a sole trader, as a sole proprietor, which is treated as a sole proprietor for tax purposes, as a spouse partnership, or as an LLC, which is treated as a spouse partnership. Great. This means that you can hire your child under the age of 18 as a legal employee and his or her salaries will be exempt from social security tax, Medicare tax and federal unemployment tax (FUTA). In fact, FUTA’s tax exemption continues until your child is a 21-year-old employee. You can hire your child part-time, full-time or anything else.

The standard deduction for your dependent child employee can accommodate up to $ 12,950 of the 2022 salaries your business receives from federal income tax. OK.

Bottom row: Your child will not owe anything to federal agencies for the first $ 12,950 salary unless he or she has income from other sources. The child can then set aside part or all of the salary and contribute to the Roth IRA (more on this later) or a college fund.

Tax benefits for you

When you hire your child, you receive a business tax deduction – for employee payroll costs – for money you have just given to the child anyway. The deduction reduces your federal income tax account, your self-employment tax account, and your state income tax account, if applicable.

If your business is registered

What if you run your business as a corporation? In this case, your child’s salaries are subject to social security taxes, Medicare and FUTA, just like any other employee. However, there are still many tax breaks. You can deduct your child’s salaries as a business expense from your corporation’s tax return; your child can be eligible for federal income tax salaries with a standard deduction of $ 12,950; and your child can set aside a portion of their salaries in a Roth IRA or college fund.

Play the angle of the Roth IRA

The only tax requirement for your child to make an annual contribution to the Roth IRA is to have earned income for the year that is at least equal to that paid for that year. Age is completely irrelevant. So, if your child earns money from summer work or part-time work after school, he or she is eligible to contribute to Roth for this year.

For tax year 2022, your child can contribute less than: (1) their earned income or (2) $ 6,000. While the same $ 6,000 contribution limit applies to the Roth IRA and the traditional deductible IRA, the Roth option is almost always better for children for reasons explained later.

A modest contribution to the children’s Roth IRA can indeed be added

By contributing to Roth for just a few years during adolescence, your child can potentially make a lot of money by retirement. In reality, however, most children will not want to contribute an annual maximum of $ 6,000, even when they have enough income to do so. Try to get a teenager to save a significant amount of money instead of spending it all. Good luck. So you, as a realistic parent, should be happy if you can convince your child to contribute at least a significant amount each year. Here’s what can happen.

* Let’s say your 15-year-old contributes $ 1,000 to the Roth IRA at the end of each year for four years. Assuming a 5% annual return, Roth’s bill will cost about $ 33,000 in 45 years when the “kid” is 60 years old. If you accept a more optimistic return of 8%, the bill will cost about $ 114,000 in 45 years.

* Let’s say a child contributes $ 1,500 at the end of each of the four years. Roth’s bill will now cost about $ 49,000 over 45 years, assuming a 5% rate of return. With a return of 8%, it would cost about $ 171,000.

* Let’s say the child contributes $ 2,500 at the end of each of the four years. Assuming a 5% return, Roth’s bill will cost about $ 82,000 in 45 years. If we accept a return of 8%, the value of the bill jumps to a whopping $ 285,000.

You understand the idea. With relatively modest annual contributions in just a few years, Roth IRAs can be worth the eye-catching amounts as the “kid” approaches retirement age.

For children, Roth IRAs are almost always better than traditional IRAs

For a child, contributing to a Roth IRA is usually a much better idea than contributing to a traditional IRA, which is deductible for several reasons. First, your child can withdraw all or part of Roth’s annual contributions – without federal income tax or penalties – to pay for college or other reasons. However, Roth profits usually cannot be withdrawn without taxes before the age of 59½. In contrast, if your child makes deductible contributions to a traditional IRA, all subsequent withdrawals must be included in gross income. What is even worse is that traditional IRA withdrawals taken 59 years ago will be hit by a 10% early withdrawal tax, unless an exception applies (one exception is to pay for higher education).

Important point: Although your child can withdraw Roth contributions without any adverse effects on federal income tax, the best strategy is to leave as much of Roth’s account balance as possible until retirement age to earn more. -large amount exempt from federal tax.

How about tax breaks for traditional IRA contributions, you ask? Isn’t that an advantage over the Roth IRA? Good question. There are no write-offs for Roth contributions, but your child will probably not receive any meaningful write-offs of contributions to the traditional IRA. This is because, as explained earlier, the standard deduction for an unmarried dependent child will automatically shelter up to $ 12,950 of the 2022 federal income tax revenue earned. Any additional income will almost certainly be taxed at very low rates.

So, unless the child does not have enough taxable income to owe a significant amount of tax (unlikely), the theoretical advantage of being able to deduct traditional IRA contributions is almost or completely useless. Because it is only An advantage that a traditional IRA has over a Roth account, the Roth option almost always comes first for children.

Bottom row

As you can see, hiring your child can be a sensible idea for taxes. In addition, it is probably much easier to hire a family member now than to hire an outsider given the busy labor market. In addition, hiring your child saves more money in the household.

Remember, however, that the child’s pay must be reasonable for the work done. So the strategy of hiring your child works best with teenage children who can be assigned meaningful tasks.

Keep the same records as you would for any other employee to confirm hours worked and duties performed (eg schedules and job descriptions). And don’t forget to give your child a 2022 W-2 form early next year, just as you would for any other employee.

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