If you were to ask accountants what one of the most misconstrued tax strategies they’ve heard floating around the internet are – and there are many – they’d probably point you to the constantly overexaggerated claims about paying your kids as employees of your company. To be fair, it doesn’t always deserve its bad rep. It isn’t just the brainchild of a scheming child or fraudulent tax preparer. Paying your children CAN be a legitimate tax strategy that helps you save. It just comes with several guidelines and caveats that are largely missing from the viral social media anecdotes. We will look at the four major ones in this article.

Let’s start with the bigger picture first. The crux of this strategy is that wages paid to your child under 18 are exempt from Social Security and Medicare taxes, and wages paid to your child under 21 are exempt from federal unemployment tax. In addition, the wages can be sheltered from income tax up to the annual standard deduction. The major disqualifier before the work even begins is that it has to be a sole proprietorship or a partnership where each partner is the parent of the child. If there’s a single outside partner or C-corp, the exemption is gone. If that is the case, then there are four things you’d need to make sure that this tax strategy is legitimate in the eyes of the IRS.

The work needs to be legitimate and age-appropriate. The work has to be a task that adds value to your business and makes sense for someone of that age to be involved in. Standard administrative work or even cleaning might count but walking the family dogs and household chores do not – even if your sole proprietorship is run from home. Your 8 year old being involved as a fractional CFO is a hard sell to the IRS.

The pay has to match what you would pay an outside hire. Severely inflated wages that don’t make sense in comparison to the work is a big red flag. If you would hire an outside person or your neighbors kid to do the work for $20, you would need to pay your child $20. The IRS will be looking at the hours and wages to assess its legitimacy.

It needs to be run through payroll with actual documentation. You’ll need to keep timesheets with dates and tasks, a real pay schedule and a W-4, a W-2 and income tax withholding included correctly. Even though some taxes are exempt, you will need to treat it like you would any other payroll situation to have the correct paper trail for the IRS. One lump sum or a timesheet created AFTER the fact has disqualified previous tax cases.

The money has to be distributed to the actual child. The money must be sent to a bank account in their name that they have access to. Distributing into your own account and paying your own household expenses or telling the courts that you distributed to them from there will not be acceptable. Once it’s theirs, you can direct it to their expenses or a custodial Roth IRA.

As you can see, paying your children can be a legitimate tax strategy that helps both you and them. They get the work experience and joy of earning their own living and you get to reap the tax savings and an extra hired hand. Keeping the guardrails in mind will help you hold on to your savings and avoid messy tax court cases that rarely go well. Avoid any and all unscrupulous internet accountants encouraging you to pay your toddler $50K to work at your factory. At ClarkSilva, we advise companies on savvy tax saving strategies and how to plan for the best future possible, including involving your children. If you have any questions at all, reach out to us today!