If you own your business and have children, you should definitely consider employing your kids.
It can be a wonderful tax planning strategy because the business can deduct your kids’ wages and your children will have to pay little to no federal income taxes on their earnings. The IRS has accepted that a child as young as 7 years old can be an employee of a family-owned business.
In order to properly do this, you will need to go through every step you normally would for hiring a new employee (such as filling out a W-4, giving them a paycheck, etc.). Your children will need to deposit their wages into their own bank account, and they will need to file their own taxes.
You should claim your children as “personal exemptions” as you normally would, giving you a $4,050 deduction per child in 2016. Since you’re claiming their exemptions, your children will not be able to claim themselves.
However, your children will be entitled to the standard deduction, which will reduce their taxable income by $6,300 for 2016. So the first $6,300 of their wages will end up having no taxes due on them. In addition, the first marginal tax rate is only 10 percent and this on the next $9,275. So you could pay your child $15,575 and they would only owe around $928 in federal taxes. This should be significantly lower than your own marginal tax rate.
If your small business is a sole proprietorship or a partnership (must be family-owned), then the wages paid to the child are not subject to Social Security and Medicare taxes (which equates to saving $15.30 on every $100 you pay them). If your business is an S-corporation, then their wages will be subject to Social Security and Medicare taxes.
Now that we’ve established the basics of paying your children, the next question is what should be done with their earnings? One option is for the child to pay for normal family expenses, like groceries. Another popular option is to have them invest in a Roth IRA ($5,500 is the annual limit).
Your children would contribute their after-tax earnings into the Roth IRA. The money could be invested in stocks, bonds, mutual funds, etc. and grow tax-free. They could withdraw up to the exact amount of their contributions (not their earnings) at any time tax-free. Once they reach age 59 ½, they may withdraw as much as they would like tax-free. There also are special tax-free earnings withdrawal exemptions for first-time home purchases and college expenses.
This strategy could incredibly enhance your children’s financial future. For example, if your child invested $5,500 per year from age seven through 18 and nothing after that, and the money earned a conservative 7 percent annually, by age 60 they’d have $1,488,289.57 tax-free dollars available to them.
If they’d like to invest even more every year, they could open their own 529 College Savings Plan, which works similar to Roth IRAs when the money is used to pay for college expenses.
As with all matters of tax planning, it is critical that you make sure you document everything and consult with a certified public accountant.