Hiring your kids is a great tax strategy that may save you a significant amount on your taxes. In fact, the higher your tax burden, the more you may be able to save by hiring your kids. This can also aid your efforts to save for college significantly.
However, as with all business deductions, you must be diligent to comply with state and IRS regulations and follow best practices to ensure success and avoid abusing this opportunity. There are numerous compliance measures that you must follow to avoid abusing this opportunity.
Why hiring your children may be a great idea
When you hire your children to work in your business, you can deduct their salaries from your business income as a business expense. If your child is under 18 years old, you generally do not have to withhold or pay Social Security or Medicare tax on their salary, though there are some exceptions.
Tax filing requirements vary by state, but according to IRS filing requirements, your child must pay taxes on their salary only if it exceeds the federal standard deduction amount for that particular year. For example, your child would only pay federal income taxes for 2022 if their salary exceeded $12,950, which is the rate for single taxpayers. If you pay your child more than the federal standard deduction amount for the year, they must pay taxes according to the year’s federal income tax rate.
To put this in perspective, if your child earned $23,225, they would only pay a total of $1,027 income tax (($23,225–12,950) * 10% = $1,027). The formula to calculate your child’s federal tax obligation is:
(TOTAL_INCOME-STANDARD_DEDUCTION) * APPLICABLE_TAX_RATE = TAX OWED
As I hinted at earlier, both filing requirements and income tax thresholds vary by state and will likely differ from the IRS’ federal tax requirements. For example, California’s state income tax rates for single taxpayers are as follows:
| Single Taxpayer Income | 2022 California Income Tax Rate |
| $0 – $10,099 | 1% |
| $10,100 – $23,942 | 2% |
| $23,943 – $37,788 | 4% |
| $37,789 – $52,455 | 6% |
| $52,456 – $66,295 | 8% |
| $66,296 – $338,639 | 9.3% |
| $338,640 – $406,364 | 11.3% |
| Over $677,276 | 12.3% |
IRS tax rules to follow when hiring your children
Though you can receive many tax benefits when hiring your children, you must be vigilant to maintain compliance with labor laws and IRS requirements. Here is a brief overview of the IRS’ tax rules you must follow:
- Rule 1 – Bona Fide & Legal: Your child must be a bona fide employee and you must comply with the same legal requirements as when hiring an unrelated employee. For example, this would include completing IRS Form W-4 and USCIS Form I-9 for your child and filing a W-2 for your child every year.
- Rule 2 – Ordinary and Necessary: Your child must be paid for services that are common, accepted, helpful, and appropriate for your business like answering phone calls, designing your website, or cleaning your office. You may not deduct payments made to your child for personal services like babysitting.
- Rule 3 – Reasonable Compensation: Your child’s compensation must be reasonable and comparable to what you’d pay an unrelated employee for performing the same tasks.
Note that FICA tax obligation varies based on business type
It’s worth noting that applicable taxes can vary based on your business type.
- If your child is under 18 years old, they do not have to pay FICA taxes as long as you either have 1) a sole proprietorship owned by one of the child’s parents, 2) a partnership where each partner is a parent, or 3) an LLC taxed as one of the first two structures.
- If your child is under the age of 21 when working for your sole proprietorship or partnership as described above, they are exempt from FUTA taxes.
- If your business is taxed as a C or S corporation, partnership (not as described above), or estate, your child’s income is subject to income tax withholding, Social Security, Medicare, and FUTA taxes, regardless of their age.
California tax rules for hiring children
For California tax purposes, the rules for hiring your children are based on Section 631 of the California Unemployment Insurance Code (CUIC). However, there is an exclusion to the definition of “employment” that is known as the Section 631 exclusion. An information sheet from the Employment Development Department (EDD) notes that this exclusion covers service performed by an adopted or biological child under 18 years old who is working for their parents or an individual who performs services for their biological or adopted child, spouse, or registered domestic partner. There are a few key points about the Section 631 exclusion to consider:
- Once your child turns 18 years of age, they are no longer covered under the Section 631 exclusion. You must then report their wages and pay applicable Unemployment Insurance (UI), Employment Training Tax (ETT), State Disability Insurance (SDI), and Personal Income Tax (PIT).
- Stepchildren, foster children, sons-in-law, and daughters-in-law are not included in California’s Section 6231 exclusion.
- This exclusion for your minor children differs from federal tax guidance since it applies even if the minor is married, living with parents, or independently self-supporting. Current federal guidance also contains no exclusion for registered domestic partners.
Best practices to follow when hiring your children
There are several best practices to ensure you receive the maximum tax benefits of hiring your children without getting into trouble with the IRS, including:
- Keep payroll records that detail hours worked, wages earned, and taxes withheld.
- Deposit wages into a separate bank account, Roth IRA, or Section 529 college savings plan for your child.
- Separate personal and familial tasks from business duties.
- Comply with child labor laws and all applicable labor laws.
- Ensure your child files a tax return
Gain the upper hand with our tax advisory services
At MBS Accountancy, our tax advisory services include year-round discussions and vigilant adjustments to ensure you are prepared to minimize tax liability, remain compliant, and maximize all available tax incentives each year. If you’d like to learn more about our tax services, contact us today.