How this tax strategy works, where it goes wrong and what needs to be documented

Key Takeaways:
  • Paying your child through your practice can lower taxes, but only if they do real work and are paid a reasonable wage.
  • The strategy falls apart fast without proper payroll, clear documentation and a true employer-employee relationship.
  • When done right, it can shift income, reduce your tax burden and help your child start building retirement savings early.

 

It usually starts with a simple question. A business owner hears about a tax strategy from a friend or colleague and wants to know whether it would work for them too.

Paying your child wages through the business is one of those strategies. In the right situation, it can create real tax savings. But the savings are only part of the story. For the deduction to work, the child has to do real work, the pay has to be reasonable and the arrangement has to be documented like actual payroll.

Can you pay your child wages from your business?

Yes, if the facts support it.

When done correctly, paying your child through the business may create a deductible business expense that lowers taxable income. Depending on how much the child earns and whether they have other income, that pay may be taxed at little to no federal income tax or at a lower rate than the parent’s income. In the right situation, that can create a meaningful tax benefit for the family.

There can also be a long-term benefit. If your child has earned income, they may be able to contribute to a Roth IRA. Starting retirement savings early can be valuable.

But this is not as simple as moving money from parent to child and calling it wages. The arrangement must meet the guidance in order to be considered a legitimate business expense.

What Needs to Be True for the Deduction to Work?

Under Internal Revenue Code Section 162 and related court guidance, wages paid to a child are generally deductible only if:

  • The wages are reasonable for the services performed
  • The wages are for actual services rendered that are necessary for the business
  • The wages are actually paid and properly documented
  • The arrangement is a bona fide employer-employee relationship

That is the real test. A child must actually work for the business, perform age-appropriate tasks and be paid a reasonable amount for that work. The arrangement should look like real employment, not a tax shortcut.

What Documentation Matters?

This is where many business owners run into trouble. Your records need to prove the arrangement was legitimate.

That may include:

  • Time records showing hours worked and tasks performed
  • A job description outlining duties and responsibilities
  • Payroll compliance, including Form W-2 reporting and any applicable withholding
  • Payment records showing wages were actually paid
  • Support for why the wage amount is reasonable

It is also important to keep personal expenses separate. Paying for a child’s personal expenses, such as clothes or other costs, does not make those payments deductible wages. If the child is being paid, the payment needs to be tied to actual work and handled through payroll.

Scenario 1: When the strategy does not work

Let’s say Jeff owns a dental practice and wants to pay his 2-year-old son $20,000 for the year after hearing about the strategy from a friend. He does not want to issue a W-2. He may pay in cash or have the business cover his son’s karate classes and count that as wages.

This scenario does not work well.

First, the child must perform actual services for the business. At age 2, that is difficult to support for most office roles. A toddler is not realistically filing paperwork, answering phones or helping at the front desk.

There may be narrow situations where a very young child provides a legitimate service, such as appearing in advertising for a pediatric dental office. But even then, the next question is whether the pay is reasonable. Would the business pay an unrelated 2-year-old $20,000 for that role? In most cases, probably not.

There are other issues too. If Jeff does not issue a Form W-2, that creates a payroll compliance problem. If he pays in cash without clear records, documentation becomes weak. If he pays karate expenses instead of wages through payroll, that looks like a personal expense, not compensation for services.

In this scenario, Jeff would have a hard time supporting the deduction.

Scenario 2: When the strategy is more likely to work

Now let’s change the facts. Jeff has a 16-year-old daughter. He pays her $20,000 for the year. She works in the office four days a week for two hours a day after school. She files paperwork, answers the phone, sends mail and runs errands as needed. During summer break and school holidays, she works additional hours, sometimes full days when staff members are out. Jeff’s office administrator supervises her work and assigns tasks.

At year-end, Jeff issues his daughter a Form W-2 and she files her own tax return. She also contributes to a Roth IRA.

This scenario is much easier to support.

The daughter is performing actual services that the business needs. Her work is age-appropriate. She is supervised. Her pay is processed through payroll and reported properly. This is the type of arrangement that looks much more like a real employer-employee relationship.

That does not mean every similar setup automatically works. The wage still needs to be reasonable for the work performed. But this is a much stronger fact pattern.

Why Healthcare Business Owners Need to be Careful

Paying your child through your healthcare business can be a valid tax strategy, but it has to be done carefully. It may lower business taxable income, shift income to a lower-tax-rate family member and allow your child to begin saving for retirement early.

For healthcare practices, this strategy can make sense because there may be legitimate work an older child can do in the office. That could include filing, scanning, organizing supplies, handling mailings, basic admin support or helping with other routine tasks.

But not every child belongs on payroll, and not every wage amount will hold up. Owners need to look at the full picture. Is the work real? Is the pay reasonable? Is payroll being handled correctly? Are the records adequate to support the arrangement?

If one of those pieces is missing, the deduction becomes harder to defend.

This is one of those strategies that sounds simple when another business owner mentions it. In practice, the details matter.

Interested in Implementing this Tax Strategy?

The Adams Brown healthcare team can help you look at whether the strategy fits your situation, determine the risks and ensure the strategy is well documented. Contact an Adams Brown healthcare accountant today.