Paying Your Children From Your Own Business

[Smokystache]

I know this subject comes up quite a bit, and often it is done in a pretty shady way. So let's briefly set the stage:
- my child has begun to do real work for my business (video editing and creating short videos for marketing purposes). This is work that I have paid outside contractors to do in the past and is absolutely necessary for my business. My child is mid-teens.
- I am currently operating as a sole-proprietor, but after moving this year I may switch to an S-corp for next year (that's another post)
- Looking to the future, I want to pay my child in a way that legally saves taxes.
- I am also encouraging my child to offer her video editing services to others (there is a niche in her hobby where she could create videos for her coaches for advertising and website content).

Online sources state that hiring a child in an S-corp is not usually financially beneficial because of the necessary withholdings. The most common "workaround" I've seen is to create a "family management company" which seems to be the way to funnel earnings to the child without paying witholdings. (Like this article suggests: https://wealthfactory.com/articles/how-to-avoid-payroll-tax-for-your-children-if-your-business-is-an-s-corp/ - to me that "feels" pretty shady. I think I have come up with a better solution.

Better solution: I think it would work better for my child to create their own sole-proprietorship and then hire them as a contract (1099 employee). If my child was 25 and a freelance video editor who I hired online, this is exactly how I would hire them. The only difference is their age. (I am not in one of the 4 states that forbit minors from owning a business).

So, to answer a few questions: I would need to strictly abide by the IRS rules governing W-2 employees vs. 1099 contractors, including:
- child should have their own tools (computer, editing software, cloud account, etc)
- child should have the right to determine when they work, and what the final product looks like
- the job duties would be very limited in scope (just video editing), not also taking out trash, filing, etc.
- I would create a clear contract for the work to be done between my s-corp and their sole-proprietorship
- sole-proprietorship should bill my s-corp and payment made to sole-proprietorship
- child is free to enter into business relationships with other companies/organizations (which I hope they will do)
- child is paid per project, not hourly or monthly
- child will file federal and state taxes annually

Again, to me this seems more like the real world. After all, why should my contractor be penalized because they are related to me? If my child was 10 years older and wasn't related to me, this is exactly how the working relationship would be categorized.
...
And now that I've typed all that out, I realize that my language of "contractor" may be messing things up. It seems like it would be even simpler to say: My child started a business (sole-prop) and my s-corp has purchased services from their business (e.g., YY videos clips @ $XXX per video clip). End of story.

What am I missing?

[secondcor521]

You can pay 1099 contractors by the hour.  It doesn't need to be by the project (although it could).

You may need to issue them a 1099-NEC in January for payments made to them, with a copy also sent to the IRS.  The old rule was more than $600 in a year, but those rules are in flux.  You have to make sure you get the proper forms - you may not be able to print them out but I think you may have to order original 1099-NECs from the IRS (or pay to use a 1099 service).

As a sole prop, they can deduct expenses related to their business too.  So if they have license fees for the video editing software those would probably count.

Check with your state to see if there are any business registration or licensing requirements.  In my state, you can either operate a sole prop with your name in the business name without any registration, or you can file for a DBA for about $100 one time fee to the Secretary of State.

If your child makes enough (over ~$435 IIRC), they will have to file Schedule SE along with Schedule C and pay both sides of SE taxes.  I think there is an exception to this for family members working in the parent's business but I am not up on the details.

And yes, the kid should file their own federal and state tax returns if required.  Note they can file their own tax return and still be your tax dependent - the two things are not correlated; sometimes people are confused on that point.

[Smokystache]

If your child makes enough (over ~$435 IIRC), they will have to file Schedule SE along with Schedule C and pay both sides of SE taxes.  I think there is an exception to this for family members working in the parent's business but I am not up on the details.

I think this was the piece that I was forgetting. She can start her own sole-prop (or LLC or whatever), but she will need to pay SE taxes. The benefit of hiring your child is that they are exempt from SE taxes. I think .

[SeattleCPA]

@Smokystache I read that at this point you're only considering morphing your sole proprietorship into an S corporation.

Thus, this comment: If child is a minor, you can employ him or her and avoid federal payroll taxes. Because of the standard deduction, child will probably also avoid both federal and state income taxes?

This old (pre-Trump tax cuts) blog post of mine goes into more detail. But just making child a regular employee may be pretty optimal. All you'd need is to have a payroll system. Something like Gusto works well usually.

https://evergreensmallbusiness.com/hiring-your-children-as-a-tax-loophole/

Note the tax rates are a little too high in the blog post and the standard deduction is way too low. This year standard deduction for single filer is $14,600 so child could earn that much as minor and avoid income taxes and federal payroll taxes mostly.

P.S. This JavaScript calculator at my little blog does S corporation payroll tax savings calculations: https://evergreensmallbusiness.com/s-corporation-tax-savings-calculator/ Very easy to use.

[Smokystache]

Thanks everyone - I'll take a closer look at the "family management company" strategy.

[Michael in ABQ]

Our business is an S-Corp with myself, my wife, and a couple of our kids on payroll. The kids make minimum wage ($12/hour locally) and get paid via direct deposit through Gusto just like us and the rest of our employees. We don't withhold any income tax as they make maybe $500-$1,000/year so they wouldn't owe any income taxes regardless. They do pay payroll taxes (Social Security/Medicare) but not enough for them to earn any credit yet (currently at $1,730 per year).