Tax Savings with Child on Payroll Strategy: A Guide for Family-Owned Businesses

The "child on payroll" tax strategy involves paying a child for work they perform in a family-owned business. This can provide several tax benefits for the family, especially when structured properly.

Here’s an overview of how it works and the potential benefits:

How the Strategy Works

1. Employment of the Child:

   • The family business hires the child as an employee, paying them a reasonable wage for actual work performed. This could include tasks like administrative work, website maintenance, social media management, or even janitorial services, depending on the child’s age and capabilities.

2. Tax Deductions for the Business:

   • The wages paid to the child are a deductible business expense, reducing the taxable income of the business. This can be especially beneficial if the business is in a higher tax bracket.

3. Income Shifting:

   • The child’s income is usually taxed at a lower rate than the parents’ income. If the child earns less than the standard deduction ($13,850 for 2024), they may owe no federal income tax at all.

4. Avoiding Payroll Taxes:

   • If the business is a sole proprietorship or a partnership where the parents are the only partners, wages paid to a child under 18 are not subject to Social Security and Medicare (FICA) taxes. This can lead to additional savings.

5. Saving for Education:

   • The child’s earned income can be contributed to a Roth IRA, which is an excellent way to save for college or other future expenses. Since contributions to a Roth IRA can grow tax-free, this can be a powerful tool for long-term wealth accumulation.

Key Considerations

1. Reasonable Compensation:

   • The IRS requires that the wages paid to the child must be reasonable and commensurate with the work performed. Overpaying the child could lead to penalties or the disallowance of deductions.

2. Documentation:

   • It’s crucial to document the work performed by the child, keep accurate records, and ensure that they receive a regular paycheck like any other employee. This includes maintaining time sheets, job descriptions, and adhering to labor laws.

3. Impact on College Financial Aid:

   • Income earned by the child could affect their eligibility for financial aid for college. The income might be counted against them in the FAFSA formula, potentially reducing the amount of aid they qualify for.

4. State Taxes and Laws:

   • The specific tax benefits and rules can vary by state, so it’s important to understand local regulations and consult with a tax professional.

5. Long-Term Impact:

   • While this strategy can provide immediate tax savings, it’s also essential to consider the long-term financial planning implications. For example, contributing to a Roth IRA can provide the child with a significant head start on retirement savings.

The "child on payroll" tax strategy can be a valuable tool for families with a small business, providing tax savings while teaching children about work and financial responsibility. However, it must be implemented carefully and in compliance with IRS regulations to avoid penalties. Consulting with a tax professional is recommended to ensure the strategy is optimized for your specific situation.