The win-win way to pay wages to your children

10/25: MoneyWatch

Small-business owners who have a family need all the tax breaks they can find. Good tax planning often includes paying wages to their children, given the many tax benefits of doing this, including:

  • The business owner can claim a tax deduction for the wages paid to the child
  • Some or all of those wages are tax-free for the child
  • Since income shifts from the parent’s higher tax bracket to the child’s lower tax bracket, the family’s total tax burden is reduced
  • Since the child has earned income (even if it’s tax-free), the child can contribute to a Roth IRA

Paying wages to a family member can be part of a smart, money-saving tax strategy. For example, if you pay your child $6,300 in 2016, it’s a tax-deductible expense for you when it’s a legitimate payment for services provided to your business. 

When you pay up to that amount to a child who has no other income, it’s also tax-free, because the standard deduction for single filers shelters the first $6,300 of income in 2016. If you’re in a 39.6 percent federal tax bracket, the federal tax savings to you is $2,495 per child.   

Even if your child has other income in excess of $6,300, this still make sense if the child is likely to be in a lower tax bracket than you. In this case, you’re shifting income out of your higher tax bracket (39.6 percent) to their lower tax bracket (say, 15 percent), so the tax savings would be 24.6 percent of the amount of the income in excess of $6,300 paid to your child.   

But doing this isn’t a slam dunk. You need to carefully follow a few steps to make sure that if you’re audited and if this matter is questioned, you’re prepared to successfully defend your position. Here’s what you need to do:

  • Document the work that the child did for your business. Make a note of the tasks performed and how it relates to your overall business.
  • Keep records of the days and hours the child worked.
  • Make sure the wages are reasonable.
  • File the appropriate tax forms to document the wages paid. This would include a Form 1099 for pay to an independent contractor, or Forms 941 and Forms W-2 for the payment of a regular wage.

The IRS requires not only that the wages are ordinary and necessary to the function of the business but that the amount paid must be reasonable for the services actually provided. When a business owner pays wages to a family member and there’s an audit, the IRS and the courts will closely scrutinize the situation to determine if there is a bona fide employer-employee relationship.

So, if you pay your child $750 per hour when the typical rate you’d pay others is $25 per hour, this would definitely raise a red flag during an audit.

Also, if you had a good year and decide to pay a large bonus to your child, be careful as to the amount and timing. Without supporting documentation, bonuses paid to a child near their birthday or during the holidays are viewed as gifts not wages. 

In that case, you’d lose the deduction for these bonus payments. Indeed, in several recent cases, the courts decided that even though the wages paid were reasonable, the bonus payments, which were larger and paid at year-end, weren’t. Therefore, the related tax deductions were disallowed.