Employing family members in a business is legitimate, common, and one of the first areas an examiner looks at — because it is also frequently abused.
Children in a sole proprietorship or family partnership
There is a genuine advantage here. Wages paid to a child under a certain age by a parent's sole proprietorship, or by a partnership in which both partners are the child's parents, are exempt from Social Security and Medicare tax, and from federal unemployment tax up to a further age.
The child can also use their own standard deduction against the wages, which means a meaningful amount can be earned with little or no federal income tax — while the business gets a full deduction at the parent's marginal rate.
Note that this exemption does not apply if the business is a corporation, including an S corp.
What makes it hold up
- The work must be real and necessary to the business.
- The child must be capable of the work at their age.
- The pay must be reasonable for the work — what you would pay anybody else to do it.
- Keep time records showing hours actually worked.
- Pay through actual payroll, on a schedule, into an account, with filings made.
- Issue a W-2.
Paying a large sum to a young child for vaguely described work, with no time records and no payroll filings, is exactly what does not survive examination.
Employing a spouse
Different considerations. A spouse's wages are generally subject to the usual payroll taxes, so the saving is not on the employment tax side. The reasons to do it are typically benefits — health coverage, retirement plan participation — and those can be substantial.
The same reasonableness and documentation requirements apply.
The retirement account angle
A child with earned income can contribute to an IRA, including a Roth. Starting a Roth at fifteen with genuine earned income is one of the more powerful things a family business can do, and it is entirely legitimate provided the wages are.
What we tell clients
Do it properly or do not do it. Done correctly it is a sound arrangement. Done loosely it is the item that turns a routine examination into a difficult one, and the adjustment usually brings penalties with it.
This article is general information, not tax advice, and tax rules change from year to year. Confirm current-year figures and talk with a professional about your specific situation before acting.
Common questions
Can I put my child on the payroll?
Yes, if the work is real, they are capable of it, and the pay is reasonable for the work. Wages paid by a parent's sole proprietorship to a child under a certain age are exempt from Social Security and Medicare tax — but not if the business is a corporation.
What documentation do I need?
Time records showing hours actually worked, payment through real payroll on a schedule, payroll filings made, and a W-2 issued. A large payment with a vague description and no records is the classic example of what does not survive examination.
Can my child contribute to a Roth IRA from those wages?
Yes — earned income is what makes IRA contributions possible, and a Roth started young is a genuinely powerful outcome. It depends entirely on the wages being legitimate.
Have a question about your situation?
Robert prepares returns for individuals, contractors, and small business owners across Weatherford, Aledo, Willow Park, Springtown, Mineral Wells, and the rest of Parker County. Bring your questions — the first conversation is free.