When it comes to running a business, every penny counts—especially as tax season approaches.

But did you know that hiring your children can not only provide them with invaluable experience but also lead to significant tax savings for you? That’s right! 

While it may sound unconventional, employing family members can open the door to significant tax benefits that many business owners overlook.

Imagine being able to pay your child for their contributions while simultaneously reducing your taxable income! 

While bringing your family members on board can create a win-win scenario, you will need a partner like doola who can keep you compliant with Internal Revenue Service (IRS) regulations and utilize smart solutions to leverage these financial perks. 

Dive in with us as we unravel the potential savings and advantages of turning family teamwork into fiscal success!

Tax Benefits of Hiring Family Members

Bringing your family into your business operations allows you to take advantage of lower tax rates and deductions. For example, you can deduct their salaries from your business income.

It will reduce your tax bill and shift income to family members in lower tax brackets, thereby decreasing your overall federal tax liability.

If they are children under the age of 18, they won’t have to pay taxes since children are exempted from Social Security and Medicare taxes.

While hiring your family may not be your first choice, it’s worth considering as part of your overall financial strategy.

Here are a few proven strategies that can help you save more money in tax savings:

Income Shifting

When you hire family members for your business, you are basically shifting a part of your revenue to them.

This allows you to redistribute the income among family members.

Since they are potentially in lower tax brackets, they are exempt from social security, Medicare, and unemployment taxes. These taxes typically make up a significant portion of an employee’s wages and can be quite costly for employers.

For example, if your business income is $100,000, then you’re in a 24% tax bracket.

However, if you hire a family member and pay them a salary of $40,000, that family member is in a 12% tax bracket.

• Before hiring your children, your tax amount was $24,000.

• After hiring your children, your tax amount becomes $14,400.

• Also, your children will pay the tax amount of $4,800.

• So, the total tax paid becomes $19,200 compared to $24,000.

So, this income shift reduces your taxable income by $40,000, yet the exact amount is still part of your family income.

Plus, the total amount of tax paid by the family is now lower than if the entire income was only subject to the 24% tax bracket.

Potential Deduction in Employment Taxes

Hiring family members also means reduced employment taxes. When you hire your children in the business, you don’t have to pay Social Security and Medicare taxes for them up to a certain age (currently 18).

For example, if you pay $15,000 in wages to your children below 18, you end up saving $2,295 in Social Security & Medicare Taxes.

However, if you hire an employee above the age of 18 and pay them the same wage, you only save $708 in Social Security & Medicare Taxes.

Family Tax Credits

Hiring family members in your business can also make you eligible for certain credits to lower your taxable income. One example of this is the Child and Dependent Care Tax Credit (CDCTC).

By offering an on-site child or dependent care facility for your employees, including family members, you can claim 35% of the cost of providing the care benefits, up to a maximum of $3,000 per qualifying individual and $6,000 per family per year.

Tax Benefits of Hiring Your Children

The majority of US small business owners employ their children.

These family-run businesses are at the heart of the US economy, especially since they teach the next generation integrity, responsibility, and a strong work ethic.

Plus, they witness firsthand the intricacies of running a business and know what to do when working towards their dreams of becoming business owners.

That’s why the Internal Revenue Code (IRC) has been nurturing and supporting small family businesses.

Even the IRS website iterates, “One of the advantages of operating your own business is hiring family members. This has paved the way for a range of tax advantages, specifically catering to the unique needs—and benefits—of family-operated ventures. 

✅ QBI Deduction

Employing children in the family business can impact the Qualified Business Income (QBI) deduction. If you employ your children in your business, their wages are a deductible business expense.

This deduction lowers your overall business income, which in turn reduces the amount of QBI subject to the 20% QBI deduction. This is because QBI is calculated after deducting wages and other expenses.

This is beneficial for parents whose business income is close to the phaseout range of the QBI deduction. By reducing their taxable income through their children’s salaries, parents can increase the QBI deduction they’re eligible for and further multiply the tax savings.

However, when determining wages for your children, consider the trade-off between the reduced QBI deduction and the potential tax savings from shifting income to them.

It will allow you to calculate the overall impact on your tax liability, not just the QBI deduction in isolation.

✅ Turning Expenses into Savings

Shifting financial responsibility from parents to their children allows parents to save more taxes and children to become financially independent. 

For example, let’s look at a family-owned clothing store, which the parents use not only to provide for their two teenage daughters, aged 15 and 17.

However, in this family, the daughters are not just helping hands; they are active employees in their parents’ business. 

Also, parents bear the costs of their children’s needs, from clothes to extracurricular activities. Let’s assume that the parents generally pay the daughters $1,200 monthly and $14,400 annually.

These young workers earn this amount for helping out their parents in their business, which is not subject to federal income tax. 

So, the money, which would have been paid in taxes by the parents, is now untaxed at the federal level. The result? A substantial reduction in the family’s overall tax liability.

But the benefits of this setup extend far beyond tax savings. By paying for their expenses from their wages, the daughters have turned their expenses into tax deductions for their parent’s business. 

Plus, they’re not just earning—they’re also learning the knowledge and skills they need to be in control of their financial future.

✅ Roth IRA Contributions and Distributions

Now, let’s focus on how hiring children allows their parents to start saving for their future from when they are teenagers. 

The benefit of having kids contribute their own money for their future savings is that it shifts income from the parent’s tax bracket to the kids. And because they’re employed, they are eligible for a Teen Roth IRA.

As a parent, you can contribute to their Roth IRA up to the amount of their earned income, with a maximum of $6,500 in 2023. This allows them to start compounding their money early and enjoy tax-free withdrawals in retirement.

For example, let’s assume your child contributes $6,500 ($575 a month) starting at the age of 13. So, at the age of retirement, your children will end up with $36 million at an 11% growth rate. 

However, if they start contributing at the age of 18, by the time they become 69, they will have just under $15 million in tax-free distributions, which is $21 million less.

So, at the age of retirement, your children will be able to withdraw all of the IRA contribution tax-free, essentially never paying a dime in federal taxes. 

However, distributions from IRAs can be taken without penalty if the proceeds are used to pay for college. 

They could also use the first-time home-buyer exclusion to withdraw up to $10,000 for a down payment on their first home.

✅ Tax Deductions through Health Insurance

As a business owner, you may already be aware that providing health insurance can bring significant tax benefits. However, when it comes to hiring your children, these benefits can become even more lucrative.

By offering health insurance to your children who work for your business, you are essentially converting what would have been personal after-tax expenses into deductible business expenses. 

This means that the premiums paid for their coverage can be deducted from your taxable income as a business expense. Additionally, if you have a group healthcare plan for all employees, including family members, you may also be eligible for additional deductions or credits.

Best Practices to Keep in Mind While Hiring Family Members

Before hiring family members for your business, it is essential to understand the requirements and guidelines set by the IRS.

These requirements ensure that family members are hired fairly and without misuse of tax benefits.

1. Relationship

The first requirement for hiring family members in a business is that they must be related to you by blood or marriage. This includes children, parents, siblings, grandparents, grandchildren, and spouses. 

While cousins and other extended relatives may not qualify, step-relatives such as stepchildren or stepparents are usually considered eligible.

2. Legitimate Work

To claim tax deductions on wages paid to family members working in your business, their work must be legitimate and necessary for the operations of your company.

This means that they must have specific job duties and responsibilities outlined in writing like any other employee.

3. Reasonable Compensation

When hiring family members in your business, it’s essential to pay them a reasonable wage based on their job duties and responsibilities.

Paying them much more than what they would earn elsewhere could raise red flags with the IRS.

4. Proper Documentation

Proper documentation of all payments made to family employees, including salary records, timesheets, employment contracts or agreements signed by both parties and any other relevant documents, is essential to avoid any discrepancies or issues with taxes later on.

IRS Requirements for Hiring Family Members

We now know that the one major benefit of hiring a family member is the ability to lower the tax income.

However, it is essential to follow proper payroll procedures when hiring a family member in your business. 

This means treating them as any other employee by setting up an official employment agreement, determining their salary or wages based on their skills and experience, and ensuring they are paid regularly with proper documentation.

By including your child on the payroll, you can contribute to their retirement plan, which will benefit them and reduce your taxable income.

You must also issue proper tax forms for your family member-employee to avoid any legal issues with the IRS. 

All employees must receive a W-2 form at the end of each year, showing their earnings and taxes withheld. Accurate information is essential to ensure that these forms reflect true earnings and comply with tax laws.

In addition to W-2 forms, you must also include:

• Form 1040 (Schedule H)

• Form 8814 (Parents’ Election To Report Child’s Interest And Dividends)

• Form 8615 (Tax for Certain Children Who Have Unearned Income)

Keep in mind that hiring a family member does not mean you can pay them below minimum wage or provide them with additional benefits without following proper employment laws. 

Follow all legal procedures and treat them as any other official employee to reap the full benefits while avoiding any potential issues with the IRS.

Bring More Tax Savings On Board with doola

Do you have someone in your family who is already working for you or someone that you have been thinking about asking to work with you? 

If that’s the case, you must follow proper procedures to avoid any potential issues with tax authorities. This is where doola has got your back. 

Our team of experts can assist you with the necessary documentation and ensure that all employment requirements are met, such as obtaining a valid Employer Identification Number (EIN) and adhering to state and federal tax laws.

Get started with doola Bookkeeping to ensure your books are up-to-date to maximize your tax savings while staying compliant with all regulations.