When your children are too old for day care and too young to leave at home to their own devices, hiring them to work for you seems like a good idea. Congress, in shaping public policy through tax laws, seems to think so too. There are tax breaks for the child who works for mom and/or dad, as well as for the parent(s) who employ their children.
Like any other tax incentive, potential for abuse abounds, so rules and restrictions also abound. But the rules for hiring your own children are relatively logical and simple. The logical part requires that the child be a real employee, be qualified to do the work assigned, be doing real work necessary to your business, be paid what others doing similar work are paid, be paid as regularly as unrelated workers are paid, and that hours worked be kept in a businesslike manner.
Pay them by check, not cash. A real business paper trail is required. Pay them regularly. If the IRS sees a lump sum payment of $5,000 at the end of the year, they'll know that tax evasion, not tax avoidance, is afoot. As for a record of hours worked, a time clock is good, but a spreadsheet with hours and work description will suffice. Be sure to print sections of the spreadsheet periodically and sign it as proof of a contemporaneous record. Paying your teenager to maintain your website at a competitive wage is credible. Paying your third-grader for the same work clearly fails the smell test. By paying your child from business income, income is taken from the higher income bracket of the parent and put in the lower income bracket of the child. The child gets a standard deduction of $5,800 to avoid paying tax and beyond that will pay tax at a minimum bracket as opposed to the higher bracket of the parents. The "kiddie tax" which taxes a child's income at the parent's rate only applies to unearned income. There is no kiddie tax for earned income of the child.
If the business is a sole proprietorship, or if it is a partnership with both partners being the child's parents, and if the child is under 18; then no social security tax (by either the employer at 7.65 percent (FICA) or the employee at 5.65 percent FICA) is due. Also, no federal unemployment tax assessment (FUTA) taxes (6.2 percent federal, but usually a net of 0.8 percent due to credit for up to 5.4 percent state unemployment taxes (SUTA) paid) are due.
The whole family saves on taxes. Parents don't have to pay their share of the child's FICA, the child doesn't have to pay FICA, and the parent's self-employment tax is reduced due to the deduction for paying the child. Be sure to issue a W-2 to the child, not a 1099. A 1099 would cause the child to owe self-employment tax!
Children must file an income tax return if 1) they have earned income of $5,700 or higher, 2) they have unearned income (investment income) of $950, or 3) they have gross income (both earned and unearned) in excess of the larger of $950 or their earned income plus $300.
By earning a wage, your child is eligible to put money away for retirement to the extent they earn money. If son Fred earns $5,000 this year, he can put that much into a Roth IRA. He can also put it into a regular IRA. Since he will get a deduction for contributions to a regular IRA (but not a Roth IRA), he'll still have his entire standard deduction available to cover more earnings for the year.
For example, if Fred earns $10,800 in 2011, he can shelter $5,800 with his standard deduction and another $5,000 with his regular IRA contribution deduction. Note that Fred does not have to deposit his pay in the regular IRA. It can come from anywhere, including the largesse of mom and dad. Mom and Dad could make a gift to Fred, and he could use it to fund his regular IRA. Furthermore, if mom and dad are in the 28 percent bracket ($139,350 to $202,300, if joint), they get to deduct $10,800 from their income, yielding an income tax savings of $3,024, a self-employment savings of $1,436, an employer FICA savings of $826.20 and a FUTA savings of $86.40. For those not keeping score at home, that's $5,732 for mom and dad. For Fred, the FICA savings are $610.20 and income tax savings (due to the IRA contribution) of $500.
An employer may create a simple pension plan (SEP) for all employees, and if one is created for the child, contributions by the child and the employer are not reduced by IRA contributions. However, if a SEP is offered, it must be offered to all employees in the same classification.