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When Paying Your Kids as Employees is Not a Wise Move for Business Owners
Business owners often explore various strategies to minimize their tax burdens, and one popular suggestion found on the internet is to hire their children as employees. By paying their kids wages, business owners aim to reduce their taxable income. However, it’s important to understand the limitations and drawbacks associated with this approach. In this article, we will delve into the concept of paying children as employees and explain why it may not always be a beneficial strategy for business owners.
- Limited Tax Savings: While paying your children can result in potential tax savings, the actual benefit may not be as significant as it initially appears. The tax savings are contingent upon being in a high tax bracket, typically around 35%. If you are in a lower tax bracket, the marginal tax rate reduction may not justify the effort and associated costs involved in running payroll for your children.
- Taxation of Other Income: If your children have other sources of income, such as part-time jobs or investments, paying them as employees may not provide the desired tax advantages. The additional income could push them into a higher tax bracket, negating the potential savings obtained by paying them through your business.
- Administrative Burden and Costs: Employing your children as formal employees entails various administrative tasks and costs. You may need to hire a payroll provider or a CPA to handle payroll processing, file payroll tax reports, and ensure compliance with state and federal regulations. The time and resources spent on managing payroll can divert your attention away from core business operations.
- Alternative Opportunities for Your Children: By hiring your children within your business, you may inadvertently limit their opportunities for personal and professional growth. Allowing them to seek employment outside the family business exposes them to different work environments, diverse mentorship, and a wider range of experiences. Such external opportunities can contribute significantly to their overall development and skill set.
- Complexity of Payroll Tax Regulations: Navigating payroll tax regulations can be intricate and time-consuming. The risk of making errors in payroll calculations or documentation increases when handling the process yourself. Engaging a payroll provider or CPA adds to the operational costs but ensures compliance with ever-changing payroll tax laws.
While paying your children as employees to reduce tax liabilities might sound appealing, it is crucial to evaluate the potential drawbacks and associated costs. The effectiveness of this strategy depends on your current tax bracket, your children’s other sources of income, and the administrative burden it places on your business. Considering alternative avenues for your children’s professional development and the complexity of payroll tax regulations will help you make an informed decision that aligns with both your business and your family’s needs.
Why Should Business Owners Not Pay Their Kids as Employees?
You might have heard on the internet that a lot of business owners pay their kids as employees to reduce taxes. And today’s question is not about why is that a good idea, but rather, when is it a bad idea? Let’s talk about the general concept so that you have a good understanding of it because then when I explain when it is a bad idea, the answer will make more sense.
Let’s imagine that you, as a business owner, bring in a million dollars and I am picking that because it is a round number and it is high enough to get into high tax brackets. So in the United States, we have a progressive tax system, which means for the first chunk of money that you earn, you don’t pay any tax. In the next chunk, you pay a higher tax rate. In the next chunk, you pay a higher tax rate. And if we say, for example, you are in a 35% tax bracket, it doesn’t mean you pay 35% on all of your taxes because the first part is exempt. The next part is at a lower bracket. The next part is at a lower bracket. But what it means is the money you receive beyond the last tax bracket is taxed at 35%. And by the way, not only are you paying 35% to the federal government on federal income tax. If you are in a state with a state income tax, you will also pay that percentage. And then there is a separate percentage that is being paid for payroll tax.
I usually recommend working with a CPA to figure out how you should do this. But I will give you a general overview here. First off, in order to have a child work for you, they have to be old enough to actually perform that work. So if they are two years old, they can’t do most tasks. What they could do is model. So in other words, they could be a model for clothing or products that you feature on your website or photos for other purposes that you feature on your website. So a child can be paid for modeling, but usually, child wages need to be paid to children who are old enough to actually get the job done and do the work. And that is because the IRS says the amount you pay your children needs to be a fair market wage.
So here is the scenario. Imagine you are earning a million dollars a year, and let’s imagine that your children can earn $12,500 per year without being subject to income tax. The standard view on the internet is, “Hey, why not take your $12,500 and pay it to that one of your children? That reduces the tax of say 35% that you are at in that bracket to zero.” Well, it does, but there is something missing from the analysis. When you pay a child for doing work, although they don’t pay income tax, you do have to pay payroll tax on them. And usually, that is about 15%.
What is Payroll Tax?
So payroll taxes, Medicare, FICA, it is all those withholdings on your paycheck. You remember when you got your first paycheck at your first job and you calculated your hourly wage times the number of hours you worked and you realized, “Oh, I am going to make this much money.” And then you got your paycheck and it was this much money? The difference there was all those portions that were withheld and sent to the government. Typically, the employee pays about seven and a half percent. The employer pays about seven and a half percent, but in light of the fact that you are thinking about this in the same family, there is a tax savings for you, but it is not as great as you might think. So imagine you are in a 35% tax bracket, and now that your child is not paying any income tax on that, you have just saved 35%, but you have to add back 15%. Now, if you are doing the math, you realize, well… Still, 15% is lower than 35%. Why not do it? Here are the reasons why you might not want to do it. If you are not in a 35% tax bracket and you are in a much lower bracket, then the math may not make sense. There might be a small benefit, and there are some costs associated with paying your kids. First off, you have payroll costs, so you might need to pay a payroll provider or a CPA to handle the payroll for you to pay out to the kids. Next, the government requires that you file reports, in Minnesota, quarterly reports to the government for the payroll tax. And you typically have to pay that payroll tax each quarter. So as you can see, even though there are some tax savings, it now becomes annoying that you have to start making payments and filing reports, and paying somebody to run the payroll for you. Now, can you do the payroll yourself? You can, but you may risk doing it wrong. And the time you spent trying to figure out your state and federal payroll documents and all that is involved with the calculations there is often better spent running your business as a business owner. So typically, it costs about right now in 2023, about $50 a month to pay a payroll provider like paychecks or ADP to run payroll for you and typically, a CPA will do that for you as well.
So to summarize, why might it not make sense to pay your children? Well, if they have other jobs, that money will now be taxed. Second, the tax savings may not be as significant if you were not in a high tax bracket. And then third, there are costs associated with running payroll.
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