Everyone wants to know how to pay less tax, and there are two smoking guns that never fail: make less money and spend more. The first, is almost never a good idea. The second, is only rarely a good idea. Frivolous spending is a tax savings trap that denies the tax man his 30 cents by denying you your 70 cents. Businesses should only spend money when it is necessary or when it is intelligent. Necessary spending keeps the lights on and intelligent spending generates other benefits in conjunction with tax savings. One potential smart spending idea for business owners is to hire their children.

Why Can it Save Tax?

For illustrative purposes we will make a few assumptions and show this in a simple framework. In reality every situation is unique and the tax code and labor laws have specific rules depending on your business and its structure. As such, if you have an interest in this topic, please contact Dermody, Burke & Brown to analyze your situation and outline your best course of action.

Money paid to children moves from your income tax return to theirs. Usually that means a big step down in the tax bracket. For federal tax purposes the highest regular income tax rate an individual can pay is 39.6% and the lowest is 0%. We will assume the most extreme situation and place you in the top bracket. We will also place your child in the bottom bracket, this can be done by restricting the gross wages paid to the child to the federal standard deduction for the year.

For 2016 the federal standard deduction for a single individual is slated at $6,300. That means the first $6,300 paid to your child is shielded from federal income tax. It is likely still subject to federal Social Security and Medicare taxes, except in a narrow margin of instances, but that combined tax rate is only 15.3%. So instead of paying $2,495 in federal income taxes, you will pay $964 in federal payroll taxes. In addition, half of that payroll tax paid is also taken as a deduction for employer taxes, saving you another $191. The overall tax saving of our simple scenario is $1,722. By spending $7,264 you save 24 cents in tax on every dollar, and $5,818 stay in the family.

In order to take advantage of this savings certain requirements must be met:

1. The child must actually perform the work they are paid for.
2. The amount paid must be fair for the work performed.

So how hard does your kid need to work? Let’s assume that the fair rate paid to your child for the job is New York’s minimum wage as of the writing of this article, or $9.00 per hour. So in order for the scenario above to work the child needs to work a little under three hours a day in a five day work week for the year. Functionally, you save $2.46 in tax for every hour your kid works.

What Makes this Smart Spending?

A dollar in your kid’s pocket is still a dollar out of your pocket. So what makes this a good idea?

You Were Probably Going to Spend It on Them Anyway.

Kids need some things, and they “need” a lot more. That $20 action figure was never going to be tax deductible before. Now, it kind of is. If we bring this back to our simple framework regarding tax savings from before; you need to spend $23 in wages and tax so your kid can afford that cool toy, whereas you needed to make $28 pre-tax to buy them that toy before. You just saved $5 on that toy. Eat your heart out extreme couponers!

Save Money by Spending Time With Your Kid.

The unfortunate reality is that many of us end up spending a large portion of our lives working. That can constrain how we use the rest of our time. If you find yourself wishing you can a couple of extra hours to spend with your family each day this can be a good way to kill two birds with one stone.

Building a Succession Plan.

It might turn out that your business can be your kid's business. If your kid turns out to love what you do they might decide to do it too. The exposure they receive during this time can give them an understanding of how your business works. You could be grooming your successor.

It Can Be An Investment in Your Children.

You, probably, love your kids. Looking at this as a strictly self-serving move blinds us to the additional benefits it offers to your children. A job can be an empowering experience. It can also develop useful skills. It teaches your children the value of a dollar and can promote smart spending and saving habits that will help them the rest of their lives. And if you don’t trust your kids to use their new found income intelligently, there are investment opportunities that can allow them to begin to grow that wealth.

A Roth IRA can be a fantastic option for a young child with disposable income. For the details on how a Roth works, please see our earlier FOCUS article by Mike Burt on the subject. Generally speaking, Roths are good for individuals who expect to be in a higher tax bracket later in life. After tax dollars are invested and income accrues and can distributed tax free in your child’s retirement. Hopefully your kids will never be in a lower tax bracket than right now, regardless of the political scene, it is unlikely that a 0% income tax cap will be seen in their lifetime. These factors can make them a terrific choice so long as you don’t mind tying up the money for an extended period.

It Isn’t for Everyone.

Sometimes it just isn’t a good idea to hire your kids. Beyond the question of whether the tax savings will be substantial in your situation, there are many other factors that may dissuade you. In some circumstances mixing life with work can have negative impacts on both.

If your work environment is high stress the added distraction of your kid might make it worse for you and expose them to strains you would rather avoid. It might be that you and your kid play well together, but work poorly. The last thing you want is to hurt your relationship to save a buck. You also don’t want to negatively impact your child and their future. It might be that they need to devote that time to their studies, or a job more in line with their long term goals presents itself.

Regardless of the reason, it may be the case that it is better to let this opportunity pass by the wayside. But if you are interested in looking at your own situation to determine if this strategy is right for you and your business, please contact Dermody, Burke & Brown.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.