How Hiring Your Kids Can Save You Money on Taxes
Aside from taxes, one of our biggest expenses is probably our kids. As they get older, they often get more expensive. From little $5 toys to video games that cost a few hundred dollars.
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As they get even older, we may spend money on them for cars, college, and much more. A common question that we get asked all the time is, “How can I write off money that I spend on my kids?”
Well…most CPAs will tell you that you can’t. But that may just be because they are not thinking strategically. You might be able to write off money that you spend on your kids if done correctly. We call this strategy “income shifting.”
What Is Income Shifting?
“Income shifting” means shifting money from one family member to another. This can give you the ability to write off the money you spend on your kids by turning them into legitimate business expenses.
So, rather than you giving them money for the movies or their car, have them help you out in your real estate business and pay them for working for you. This gives you a tax deduction for your real estate business. Then, they can use the money they earned to pay for their movies and car expenses.
What are some of the benefits of income shifting?
There’s a handful that come to mind right away:
- Teach the kids good working habits,
- Teach them a sense of responsibility,
- Reduce your family’s overall taxes, and
- Allow them start a tax-free retirement bucket.
Teaching them good working habits and a sense of responsibility by helping you at work probably seems pretty straightforward. But how does this help your family save on taxes?
The best way to explain it is to go over a real-life example. A few years ago, we met with Melissa near the end of the year to go over some year-end tax planning ideas. Melissa is a full-time sales employee but also has a real estate business flipping properties.
Melissa has two boys in high school. And for those of you with kids in high school, you know that it can get expensive. The boys need money for school, friends, movies, cell phones, and many other things. While we were meeting with Melissa and making small talk about weekend plans and such, she mentioned that she was going to put her sons to work the entire weekend, because she had a ton of cleaning and some fix-up stuff that had to be done on one of her flip properties.
We asked Melissa to consider paying her kids for the work they are going to do so she can take tax deductions for it. She thought that was a good idea so we helped her put her kids on payroll and legitimately incorporate them into her real estate business. So, for all the repairs and clean-up that her sons did, Melissa paid them $2,500 each and got a tax write-off for that money.
This essentially shifted the $5,000 from Melissa’s high tax rate of 37 percent to her sons’ zero tax rate. So, as a family, they saved close to $1,900 in income taxes.
This is a simple strategy that anyone can use. An important thing to note is that Melissa did not have to spend any additional money to get this $5,000 tax deduction because this was money she was already giving to her sons anyways. The only difference is that now she got some additional tax write-offs by turning her personal expense into a business deduction. So, instead of paying her sons an “allowance,” she instead paid them for helping her out and that turned those allowances into legitimate tax write-offs.
The key to income shifting is to make sure you are documenting it during the year. This means not waiting until April of the following year to create your records. Whether it is putting them on payroll or paying them as a 1099, the appropriate paperwork needs to be in place. So, make sure you are working with your tax advisor on this powerful strategy.
Here are some frequently asked questions we get in regards to income shifting:
- How old do they have to be?
The IRS has no minimum age requirement before someone can get paid. You’ve all seen diaper commercials and those kids are getting paid. For tax purposes, the key is that what you pay them needs to be reasonable for the work that they are doing for you. So, this means that you probably shouldn’t be paying your three-year-old as your “IT consultant.” Having said all that, each state may have their own limitations or restrictions on what work or how much work can be done by children under the age of 18. So, you will want to check with your own particular state on any legal work restrictions.
- W-2 or 1099?
Should you pay them as a W-2 part-time employee or as a 1099 independent contractor? There's a lot to this question that unfortunately can't be answered in a simple blog post. If you are concerned or have questions about this, we recommend you check with your employment/labor attorney. Common practice is that if your kids are young, they will mostly fall within the W-2 definition, whereas older kids may have an opportunity to act as a 1099 contractor.
- Do I actually need to give them money?
The answer to this should be obvious, but if it’s not, think about it this way. If someone else was working for you, would you be able to take a tax deduction for money you didn’t actually give them? Or be able to issue a W-2 or 1099 to them to report income that they never received? Of course not. In order to legitimately shift income, you need to actually pay them money for the work performed.
- What about payroll taxes (i.e., social security and medicare taxes)?
W-2 wages paid to a child under age 18 from a parent’s sole proprietor business or their partnership (if the parents are the only partners) are not subject to social security or medicare taxes. But if the parents’ business was taxed as an S corporation or a C corporation, then such wages paid to a child under 18 would be subject to these payroll taxes. If the child was treated as an independent contractor, they would be subject to these payroll taxes if they were paid $400 or more during the year.
- Can I shift income to my parents?
Yes, forget about the kids. Deduct your parents! Demographics are changing all the time and more people have retired or semi-retired parents who are looking for something to do. If your parents are willing to help you in your business and they are in a lower tax bracket than you, consider shifting income to them, as well.
- Tax-free retirement money for the kids
As mentioned previously, one of the benefits of paying your kids is that now they have earned income. This means they may be able to open and fund a Roth IRA! For example, if you paid your child $6,000 in wages for the year, they could open and fund that entire amount into a Roth IRA for this tax year. Imagine the power of setting up your 10-year-old with possibly 60 years of tax-free growth inside their Roth IRA!
Who Should Consider Income Shifting?
In summary, income shifting is ideal for anyone who has their own business and who financially supports other family members who are in a lower tax bracket than themselves. Remember, the key with income shifting is that you need to put this strategy in place during the year. If you wait until you file your tax returns, it will be too late.
Just by changing how you give money to your kids, if you’re like Melissa, you may able to save a couple of thousand dollars in taxes, while at the same time teaching them good working habits and setting them up for a tax-free retirement!
Questions about the above?
Ask me in the comments below.