Hiring Children to Work in the Family Business May Generate Some Employment Tax Savings

Summer is here and your kids need something to do. Why not hire them to work in your family business? If you do, it may help build their self-esteem. Plus your employment tax liability may also be a little less than it would have been if you had hired an unrelated individual to perform the task.

Income tax withholding. Regardless of how the family business is organized, it probably will have to withhold federal income taxes on the child's wages. Usually, an employee who had no federal income tax liability for the prior year, and expects to have none for the current year, can claim exempt status. However, exemption from withholding can't be claimed if: (1) the employee's income exceeds $950 and includes more than $300 of unearned income (such as dividends), and (2) the employee may be claimed as a dependent on someone else's return (whether or not the child is actually claimed as a dependent). Keep in mind that the child probably will get a refund for part or all of the withheld tax when he or she files a personal income tax return for the year.

Payments for domestic work in a parent's home are not subject to withholding tax. Withholding from remuneration for “services not in the course of the employer's trade or business” is only required if $50 or more cash remuneration is paid for such services performed by the child in the calendar quarter, and the child is regularly employed by the parent to perform the services (see Code Sec. 3401(a)(4)).

FICA and FUTA taxes. Employment for FICA tax purposes doesn't include services performed by a child under the age of 18 while employed by a parent in a trade or business that is a sole proprietorship, or a partnership in which each partner is a parent of the child (see Code Sec. 3121(b)(3)(A)). This can generate some employment tax savings for the parent. For example, let's say a sole proprietor who averages $120,000 of earnings from the business pays $4,750 to his or her 17-year-old child in 2011. The sole proprietor's self-employment income would be reduced by $4,750, a saving of $137.75 (the 2.9% health insurance portion of the self-employment tax he or she would have paid on the $4,750 shifted to the child). This doesn't take into account a sole proprietor's income tax deduction for one-half of his or her own Social Security taxes. That's on top of the $268.38 (.0565 × $4,750) in employee FICA tax that the child saves by working for a parent instead of someone else. A similar but more liberal exemption applies for FUTA, which exempts earnings paid to a child under age 21 while employed by his or her parent (see Reg. §31.3306(c)(5)-1).

There is no FICA or FUTA tax exemption for employing a child in a corporation, even if it is controlled by the child's parent, or in a partnership that includes non-parent partners. The children are subject to the same rules that apply to all other employees.