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Thanks to the Tax Cuts and Jobs Act (TCJA), if you are operating a small business as a sole proprietorship or a single-member LLC that is treated as a sole proprietorship for tax purposes, you can hire your child under the age of 18, as a legitimate employee. His or her wages will be exempt from Social Security tax, Medicare tax, and federal unemployment (FUTA) tax. In fact, their wages are exempt from FUTA tax until they reach the age of 21. You can hire your child part-time or full-time. (Publication 929, Tax Rules for Children and Dependents)
Under the TCJA, your child employee can use his or her standard deduction to offset up to $12,000 of 2018 wages paid by your business from their federal income tax. For 2017, the standard deduction was only $6,350, but the TCJA nearly doubled it because of the increase in the standard deduction. Therefore, under the new law, hiring your child is a good idea. In addition, you can claim them as a dependent on your return.
For 2018, your child will owe nothing to the IRS on the first $12,000 of wages, unless the child has income from other sources. Your child can then set aside some or all of the wages and contribute money to a Roth IRA or a college fund.
When hiring your child, you need to be careful to treat them like any other employee. This includes items such as:
- Maintaining detailed employment records including: Job description, Forms W-4, Form I-9, hourly time and attendance tracking, and a description of work performed.
- Your child is required to receive a Form W-2 for work
- Ensuring the services provided do not include typical household chores.
- The wage calculation should correspond for similar services provided by an arms-length employer.
- Issuing paychecks as you would a normal employee (e.g., weekly, bi-weekly, etc.)
- Documenting that the services are legitimate and considered ordinary and necessary for the business.
In the 2014 Tax Court Decision Patricia D. Ross v. Commissioner, TC Summary Opinion 2014-68, the decision stated if your child is not treated like other employees in a similar position, the IRS could deem the wages as not ordinary and necessary business expenses and disallow them as a deductible expense.
Case Study:
Mrs. Ross operated several businesses and hired her three children to perform services. The work performed by the children was mostly legitimate work and timesheets were prepared. Mrs. Ross filed the appropriate employment tax returns and the children’s income tax returns where required. While the above items were a good start, Mrs. Ross did not generally pay her children on a regular basis, but rather she often made payments to third parties for expenditures that her children “directed her to make” (most of which were meals at restaurants). Also, amounts “paid” to the children had no correlation to the number of hours actually worked and there was no consistent wage rate (hourly rates ranged from $4-$30 per hour depending on the child and year). Based on all the facts and circumstances, the IRS determined that the arrangement between Mrs. Ross and her children was too dissimilar between that of a normal employer/employee relationship, and that all of the wages claimed as an expense were disallowed.
Caution: Section 162 generally allows a deduction for ordinary and necessary expenses paid during the taxable year in carrying on a trade or business. Generally, no deduction is allowed for personal, living, or family expenses. Sec. 262. The taxpayer must show that any claimed business expenses were paid primarily for business rather than personal, living, or family reasons. Rule 42(a); Walliser v. Commissioner, 72 T.C. 433, 437 (1979). To show that an expense was not personal, the taxpayer must show that the expense was paid primarily to benefit his business, and there must have been a proximate relationship between the claimed expense and the business. See Walliser v.Commissioner, 72 T.C. at 43.
With the TCJA changes in the law, it would be beneficial for anyone considering hiring their child in the above scenario to contact a knowledgeable CPA or a Tax Lawyer and follow their advice specifically. The IRS assess penalties including the Accuracy Related Section 6662(a) and (b)(l) and (2) which imposes a 20% accuracy-related penalty on “any portion of an underpayment of tax required to be shown on a return” if the underpayment is due to, among other reasons, negligence, disregard of rules or regulations, or any substantial understatement of income tax . Respondent bears the burden of production as to the penalty. Sec. 7491(c).
We are not Tax Lawyers and are not providing a legal opinion, just an interpretation of the reading of IRS Publications, the Tax Code, and Tax Court decisions.
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