Beware of social media tax advice
While social media can be great for sharing pictures and life updates with friends and family, misinformation can be shared just as easily. Relying on inaccurate tax advice can cost you thousands of dollars and may lead to an audit of your tax return. Recently, there have been a number of posts and articles shared online advising small business owners that they can easily reduce their tax liability by paying their own children to work for their business.
While this strategy may work for some taxpayers, it could cause significant tax issues for many others. You might be able to hire your child if you are employing them to perform a job that is necessary for your business, and you are paying your child an amount that is similar to what you would pay an employee that is not related to you.
Social media posts, however, try to convince every small business owning parent that you can hire your child as an employee to perform household chores or to be a model for your business in order to get a tax break. If you are considering hiring your child as an employee, one of the first questions that you should ask yourself is if you would pay somebody else the same amount to perform that job. If the answer is no, then hiring your child to perform that work is likely not an ordinary and necessary expense for your business.
How to take a tax deduction for paying your child to work at your business
In short, your child must be treated like a regular employee of your business to claim their wages as a deductible business expense. You can deduct wages paid to your child when your child:
- Is properly employed with your business.
- Is treated as an employee.
- Does work that is ordinary and necessary for your business.
- Is paid a reasonable wage.
- Has the ability to perform the work.
It is important to properly document your child’s employment and to retain documents showing that the employment meets the various requirements.
If you decide to hire your child as an employee, you should pay your child by check or direct deposit. Cash payments should be avoided. You should also clearly document the hours that they worked and the type of work that they performed. An employment contract detailing the type of work to be performed is a good idea and will be beneficial in the event of an audit.
You should also know that the payroll and withholding requirements may vary depending on the type of business that you operate. S-corporations and C-corporations will generally be required to withhold payroll taxes on the child’s earnings, whereas Schedule C businesses may not be required to withhold payroll taxes. Payroll and withholding requirements can also vary depending on the age of the child. Before your child starts earning wages at your business, talking to a Tax Pro or lawyer can help you ensure that the right processes are in place to satisfy your payroll requirements.
What are the red flags for the IRS?
When your child is an employee of your business, one of the red flags that the IRS will look for is the age of the child. If you are treating a young child as an employee, the IRS is more likely to scrutinize whether the child is actually performing work for your business that is ordinary and necessary. For example, if you employ your 5 year old child, you may receive more scrutiny from the IRS than if you employ your 15 or 25 year old child.
In addition to the age of the child, the IRS will look at the type of work that the child is performing. Your child needs to be performing work that is necessary for your business. The IRS also looks at whether or not the work could reasonably be performed by a child of that age. If you are employing your 5 year old to manage your inventory, the IRS will likely scrutinize if the child is capable of performing that type of work.
Paying your child an excessive wage will also raise red flags for the IRS. Your child should not be compensated more than you would pay a non-related employee to perform the same work. You should consider the age of your child when determining the amount of compensation. Reasonable hourly wages for a 10 year old may be different from a reasonable hourly wage for a 25 year old, even if they are generally performing the same type of work.
What are the penalties for claiming a deduction you don’t qualify for?
The IRS is aware that wrongly claiming one’s own children as an employee is a widely abused tactic that taxpayers use to improperly lower the amount of taxes that they pay. Therefore, the IRS gives these types of arrangements additional scrutiny, which results in a higher audit risk for business owners that hire their children as employees.
If the IRS determines that you have improperly deducted wages paid to your child, those wage expenses will not be allowed as a business expense on your tax return. Once those expenses are removed from your tax return, you will likely owe additional income tax, late-payment penalties and interest. The IRS may also assess negligence or fraud penalties, which could substantially increase the amount due to the IRS.
If the IRS notifies you that they are auditing your tax return because of wages paid to your child, you should work with a qualified accountant or lawyer to respond to the IRS in a timely manner. You should also preserve any documents that show the amount of wages paid, the amount of time that your child worked, and the type of work performed. Using a Small Business Tax Worksheet can also be useful for you to organize your tax documents in preparation for an audit or if you are getting ready to file your business taxes.
Tax credits and benefits available to parents
While there are numerous tax benefits that you may receive as a parent, the majority of parents are not able to legitimately lower their tax liability by hiring their minor children as employees. Most parents would be better served by making sure they are receiving the tax benefits they might be entitled to, such as the Child Tax Credit and the Child and Dependent Care Credit.
If you are not sure what tax credits you are eligible for, working with a Tax Pro can help you be sure that you are claiming all credits and deductions that you qualify to receive. Moreover, if you are a parent that can properly hire your own child as an employee, working with a Tax Pro or lawyer to structure and document the employment relationship is a great way to reduce your risk of a negative result in the event of an IRS audit.
If you have more questions about employing your children, family members, friends, or anyone for that matter, reach out to a Rocket Lawyer network attorney for affordable legal advice. If you need help with filing your taxes, get matched with a Tax Pro via Rocket Tax™ to save time and money filling your tax returns.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.
