Family reviewing their business on their computer.

Keeping a paper trail is essential when hiring children in a family business

Hiring kids to work in a family business can be a win-win all around. The kids can earn some money while learning job skills. Putting some, or all, of those earnings in a Roth IRA can lay the foundation for an abundant future. Under current law, dependents can earn up to $12,000 before they need to file a tax return.

Business owners get a tax deduction when they hire their children. Plus, if the business is a sole proprietorship or a partnership with both parents as the only partners, wages paid to children aren’t subject to Social Security or Medicare withholding until age 18.

But, there are some rules your clients need to follow, or else this could backfire, as we’ll see later in a recent tax court case.

  1. Children must be hired to do actual work for the business. The work must be appropriate for their age and abilities.
  2. Keep business separate from the household. Children shouldn’t be hired to perform personal errands or household chores.
  3. Comply with local labor laws and child labor laws. All employees, including children, need to fill out a W-4 and an I-9. Children under 18 shouldn’t do hazardous work.
  4. Children should be paid in real money with a paper trail. Children shouldn’t be paid “in-kind” with special treats. They shouldn’t be compelled to use their wages to help support the household.
  5. Pay wages must be at least minimum wage and reflect local market rates for comparable work. A teenager doing landscaping work shouldn’t be paid $30 per hour when the going rate is $15.
  6. Withhold and pay income tax and payroll taxes. Filing all the relevant payroll tax reports also helps in creating a vital paper trail. Be sure to offer to prepare tax returns for your clients’ children. Using QuickBooks® Payroll makes payroll for family businesses easy.

Sounds simple, right? But, for Brian and Betsy Ray, ignoring these rules and keeping no books for their family business meant they owed almost $210,000 in tax and penalties for 2006 through 2011.

Mr. Ray operated the National Home Education Research Institute (NHERI), a not-for-profit dedicated to performing and disseminating research on home schooling. NHERI was funded by donations, book sales and research contracts. Mr. and Mrs. Ray also earned income by giving talks and providing consulting services on home schooling.

When the IRS began investigating the Ray family in 2012, none of the family members had filed any tax returns between 2006 and 2011. Five of the six Ray children worked as office assistants for NHERI, despite the fact that NHERI was supposedly so short on funds that Mr. Ray never received a salary during those years. Mr. Ray was NHERI’s sole researcher and financial officer during that time.

The Ray children, whose ages ranged from eight to 20 in 2006, reportedly answered phones, responded to emails and took care of mailings. None of the children ever filled out timesheets or documented the work they did. One of the values the Rays taught their children was taking personal responsibility, so everyone was expected to deposit part of their earnings into a family bank account used for household expenses. No records were kept of the amounts deposited, or of the cash retained by the children.

The Rays hired an attorney to prepare the missing tax returns, but that attorney only received a few sketchy spreadsheets and hand-written notes, hardly enough to prepare complete and correct tax returns. The Rays also never provided complete answers to the revenue agent’s document requests, so the agent was forced to perform a bank account analysis.

According to the agent’s bank account analysis, NHERI paid the Ray children $260,120 over the years. No payroll reports were ever filed, nor were the children ever given W-2s or told that they needed to file tax returns. It also appeared that the cash retained by the children when cashing their paychecks was used to support the household because the deposits to the family bank account did not cover the agent’s estimate of household expenses.

Because the Rays kept no business records and because it appeared that they were disguising income that should have been paid to Mr. Ray as payments to the children, the judge re-characterized the children’s paychecks as taxable income to the parents.

This case shows the importance of reminding your clients about the rules for hiring their children in their businesses. Being a good parent includes demonstrating how to follow the law!

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