There was an overwhelming response to the post on How to Open a Roth IRA for Kids. To do so, your child needs earned income. What better way to accomplish that than them working for your own small business? Today, let’s focus on how to hire your kids the right way.
Why Work?
Hiring your kids for your own small business is great in so many ways. Work, even mundane, menial jobs have umpteen teachable points for them:
- Respect for hard work- and not getting things on a platter
- Showing up on time
- Stick-with-it-ness, which translates to grit
- Doing your best, when your boss is not your mother (and therefore doesn’t care all that much about you)
- Getting along with different kinds of personalities
- Patience, in more ways than one- including watching small earnings taking their time to grow
- Awareness and sensitivity to others who may have less and therefore need to work much more than is comfortable
- Resume building. Real-world experience may count more and more to distinguish your children from the hordes of kids whose college application talks of extensive (and expensive) volunteer trips abroad and the like.
The amazing thing is the above is not very dependent on the nature of the work. All work works.
Do’s and Dont’s of Hiring Your Kid
Like everything else, hiring your kid needs to be done the right way. Otherwise, you might find the IRS at your door.
Because paying your children, and thereby shifting income from your high marginal tax bracket to their zero/low tax bracket can be lucrative, and therefore tempting, this is on the IRS’s radar.
They will often ask you for documentation to verify that junior did indeed do the work you said he did.
Hence it is important to make sure all your t’s are crossed and i’s are dotted.
#1. Legitimate Business
You need to have a real business for which you may hire your kids. Chores around the house do not count.
Those same “chores” (not called chores, in that case) count if the child provides them to others- say neighbors, via the child’s own business.
So if your kid mows the lawn or washes the car for your neighbor, and they pay him- that counts as earned income for junior.
You can hire your kids in your small business, such as a medical practice you own.
If you are a Sole Proprietor, you may not have an EIN (Employer Identification Number). However, when you hire an employee, you need to get one. It takes barely five minutes on the IRS website here. You get it right away. The slightly weird thing is that you can apply only during office hours.
#2. Legitimate Work
You can hire your kids for real, that is, bona-fide work that needs to get done- not something you cook up to pay your kid. Something for which you would actually hire someone else.
The position may be part-time or seasonal. Full-time employment is usually not an option for minors since they are in school. Check your state’s labor laws. In case you are worrying, it has been shown that part-time gigs, about 10-15 hours a week, do not affect teens’ grades.
Some examples are kids shredding, filing, mailing bills, etc in your office. Many older kids may be able to help with website management and business social media accounts.
These are some obvious choices. Beyond them, children are allowed to get as creative and enterprising as they want to be, as long as safety is not compromised.
#3. Legitimate Pay
You need to pay your child a “reasonable” wage- that is not too low or too high for the kind of job they’re doing for you.
Pay them what you would pay any other employee for the same job. Many a times, you’ll find that’s not much- because a younger child is not really able to do all that much- and may not add up to the “hassle” of hiring the children.
Do it anyway if it will be good for the kids in other, non-monetary ways.
Do not be tempted to “max out” the kids’ Roth IRA at $6000 a year, with what they do for you. Very few kids work enough to earn big money like that. They’ll get there, maybe in their teens, maybe as adults, be patient.
Kids do need to be paid minimum wage, Federal or state, whichever is higher, at least after 90 days into the job.
#4. Check Federal and State Labor Laws
Federal Law is fairly lax when it comes to children hired by businesses solely owned by their parents (that is, there are no other owners).
As per U.S. Department of Labor’s Fair Labor Standards Act, children under 16 years of age are allowed to work any number of hours and at any time of the day, in a business owned solely by one or both of their parents, provided that the job is not in agriculture, mining, manufacturing or any occupation deemed hazardous by the Department of Labor. This is to ensure no youngsters are slaving away in sweatshops.
However, state laws may differ on some of these points- so you should check with them. Make sure you comply with minimum age, maximum hours worked, any co-ordination with school required, etc. Some states require children to have a work permit. Some have requirements for meals and breaks (these may be less relevant with the part-time hours children usually work).
You need to comply with whichever set of rules (Federal or State) is more stringent.
#5. Sign an Employment Contract
Just like you would for any other employee. Detail the work they are expected to perform, how and when they work and how much they get paid for it.
Get the other parent, or another trustworthy adult, maybe a grandparent, to sign on behalf of your child.
If you have other employees, include the provisions for child employment in the Employee Manual or your Policies and Procedures Manual for your business.
#5. New Hire Paperwork
Comply with all Labor Laws regarding new hires, as you would with any other employee.
- Make sure your business has an EIN.
- Have your child fill out IRS Form W-4. The purpose of the W-4 is so that employers can withhold the right amount of income taxes from an employee’s paycheck. Fill the form accordingly. It involves only some basic demographic information for your child and for your business, including their Social Security Number and your business’ EIN.
- Fill out USCIS Form I-9. Here are instructions on how to fill the I-9 correctly for minors. This form basically asks you, as the employer, to ensure that the worker is eligible to legally work in the U.S.
#6. Keep Good Records
It is important to keep good records of hours worked and wages paid.
Wages must be paid in cash, not in kind.
It is best if you can transfer funds electronically into their bank account, as for most adult employees. It also provides the best documentation.
Let’s take a break now and talk about how minor’s income is treated. Then we will continue with the rest of the Do’s and Dont’s:
Taxation of Minor Income
Federal Income Tax
A child may have up to $12,400 (the same as the amount of Standard Deduction in 2020) in earned income and remain in the 0% Federal Tax bracket.
Depending on the state, state income tax may be due.
The Kiddie Tax rules do not apply here because they refer to unearned income. If a child earns more than $1,100 in investment income, such as interest, dividend or capital gains, they may be required to pay taxes on such amount.
Payroll Taxes
Children less than 18 years of age hired by their parents are not subject to Medicare and Social Security Taxes (FICA/Payroll Taxes), if the business structure of the parent is a Sole Proprietorship/Partnership of both parents- and not incorporated.
Payroll Taxes are due if:
- The business is incorporated (S corp or C corp)
- The business partnership has a non-parent as one or more partners
- Child is hired as an Independent contractor, not an employee (child is responsible for paying the Self Employment Tax).
This has the corollary that the child does not accrue any Social Security credits for this duration worked.
Unemployment Taxes
You do not have to pay for Federal Unemployment Taxes for hiring your child who is less than 21 years of age, in a business that is wholly owned by the parents and is not incorporated.
State Unemployment Taxes may be due, depending on your state.
With this background information, let’s carry on:
#7. Hire Kids as Employees, not Independent Contractors
If you treat your kids as Independent Contractors for the work they do for your business, they are liable for Self Employment taxes on their income, if more than $400 a year.
It does make things easier, paperwork-wise- since you do not have to run payroll, etc.
A point of caution here: The classification between employee and Independent Contractor is actually not interchangeable. The IRS lays down rules as to who should be classified how.
Under the $400 mark, they are not liable for taxes and do not have to file a tax return.
If they make more than that, you could still classify them as Independent Contractors and just pay the self employment taxes due and file their return. But keep in mind you should be able to defend the fact that they are indeed Independent Contractors and not your employees.
What makes their Independent Contractor status more legitimate is if your child provides the same services to others.
#8. Do you need to Withhold Income Tax?
Even if your child will owe no Federal Income tax, due to earnings being less than the amount of the Standard Deduction for a single filer ($12,400), you may still need to withhold taxes and therefore issue them a W-2.
That is, unless your child is exempt from withholding because:
- they owed no Federal income tax the prior year
- and they expect to owe no income tax in the current year
The withholding exempt status needs to be renewed with a fresh W-4 every year.
#9. Do you need to Issue them a W2?
There is no minimum amount of wage below which one does not have to provide employees with a W2.
However, if your child is exempt from income tax withholding and not FICA/FUTA taxes are due, a W2 may not be needed. I have not seen this spelled out by the IRS though and I think it is interpreted differently by different people.
#10. Do you need to File a Tax Return for your child?
Even if your child does not owe any taxes, they may need to file an income tax return. Filing requirements depend on age, dependent status, filing status, amount of income, other sources of income, etc.
Income thresholds above which a minor needs to file a tax return include:
- Earned income above $12,400 (for 2020)
- Unearned income above $1,100
- If a child has both earned and unearned income, and the total is more than $12,400
- If the child has both earned and unearned income and the unearned portion is $350 or more and the total is at least $1,100
- They are an Independent Contractor and owe Self Employment Taxes above $400 in income.
Your kid may need to file a return if they had income tax withheld by an employer during the year and they qualify for a refund.
IRS.gov has an Interactive Tax Assistant that may help answer whether your child needs to file a return or not.
#11. Hiring a Child for a Corporation
If your medical practice is a corporation, such as an S-corp and you want to hire your child to do some work for you, your options are:
- Hire your child and pay FICA and FUTA taxes
- Unincorporate and change the business structure to Sole Proprietorship/Partnership. This is obviously done only if it sense in other respects, too- not just in order to hire a child
- Form a separate entity- called a Family Management Company- which is structured as a Sole Proprietorship/Partnership. This entity hires the child and is then contracted to provide services to your main business. This is obviously a work-around and therefore often piques the interest of the IRS. Do it only if legitimate.
Financial Consequences of Hiring Your Kids
#1. Tax Savings
By hiring a child, you are essentially shifting income from your higher tax bracket to your child’s lower/0% tax bracket.
If you hire 1 child and they do enough legitimate work to earn $12,400, and you are in the 37% tax bracket, you save (0.37 * 12,400)= $4588 on your Federal tax bill. More savings if you also pay state income taxes.
With more children employed, you multiple the benefit.
For high earning parents, this is a huge savings. however, kids need to be older and doing a lot of work to earn that much in a year.
#2. Increasing QBI Deduction
Paying a wage to any employee, including your child, will reduce your business’ taxable income and may qualify you for the QBI (Qualified Business Income) Deduction, if you were previously phased out.
#3. Early Start on Retirement Savings
With their own earned income, a child is eligible to open an Individual Retirement Arrangement (IRA). At their low/0% tax bracket, a Roth account makes more sense than a Traditional IRA.
The amount they are eligible to put in is the lower of total earned income or $6000 (for 2020).
How do you encourage a teen, who is looking to blow some money on small pleasures to instead stash it for retirement- which, for them, is half a century away?
You could match their earnings. So, say your child earns $1000 working for you. They put that into their Roth IRA and you “match” their contribution for them to keep.
Money is fungible. So another option is, they keep their earnings and you or a benevolent grandparent makes the Roth contribution on their behalf. The money does not have to come from them (but is still limited to the amount of their earned income or $6000 for 2020, whichever is less).
#4. Real World Financial Education
Apart from the life lessons that working imparts, it is a great financial literacy tool.
Work teaches kids about earning and saving, including for retirement. Imagine a kid, who at 12, knows what a Roth IRA is. I did not have that word in my vocabulary until I was in my mid-30’s. I missed out on all the low tax bracket years due to my ignorance.
You can take it further, any degree you want- teach them about budgeting and investing and the basics of taxes.
I hope that was helpful for your to navigate the issue of whether or not to hire your kids for your business and how to go about it.
I do want to impress upon you that this is no way mandatory. Many of us do not have the avenue to do this because we may not be business owners. Or our business may not be tenable for kids to work in.
Your kids’ financial success does not rest upon working for dad or having a Roth IRA at the ripe old age of 5.
Healthy financial habits are much much more than that. And they learn a lot of it from you.
One of the best books I have ever come across teaching parents how to navigate financial education for kids is Ron’s Lieber’s The Opposite of Spoiled. I like it so much that I wrote the 5-minute version of it for those too busy to pick up the book.
None of this is meant as professional advice. I am not a licensed tax professional, financial advisor or attorney. Please use this only as general information and consult the professionals who do this for a living.
Want to Read More?
Do Children Need To File A Tax Return To Fund Their Roth IRA?
Hiring Children In The Family Business For Tax (And Other) Benefits
I pay my kids $120 a month to do some paperwork for me. I opened a roth IRA for them but never had a contract or have them sign any W4 or I9. My accountant have not said anything….I also dont have a EIN, am a sole prop. Sounds like I am in trouble. Maybe I should stop the ROth ?
Hi, my apologies for this late reply!
You will be in trouble only if audited- otherwise, there is no way for IRS to know since you’re not filing a return for them. You do not have to stop the Roth- just go about what is required now.
I am also not surprised that your accountant did not have much to say. Kind of like the Backdoor Roth, these things are not common- so many accountants do not know much about them.