It's a lot harder than social media makes it look to legally justify a deduction from your small business income for a child's wages
One nugget of free tax advice that pops up a lot on social media during tax-prep season is a strategy for business owners to pay their kids wages and then deduct that as an expense. Your kids get earned income, which they can then contribute to a Roth IRA, and you save money on your taxes.
Sounds like a no-brainer. Except, it isn't.
It's actually very hard to make this deduction work, and there are plenty of tax court cases where business owners have lost their appeals and had to pay penalties and interest. "The wages have to be ordinary and necessary," says Brandon Hall, a CPA who runs an accounting firm based in Raleigh, N.C.
So, what's in: Raking leaves at rental properties for $15 an hour during the fall, bussing tables at a family-owned restaurant for 25 hours a week or data entry for 10 hours a week at a parent's law practice.
Out: Emptying the garbage in a parent's home office, getting paid $13,000 a year for watching the baby so a parent can work, dancing in the background of social-media videos promoting a parent's lumber business.
"The key question to ask is would you pay somebody else the same amount of money to do that job?" says Hall.
If the answer is no, then the wages cannot be deducted from your business income.
Other key questions to ask
Your accountant should ask you the questions you need to answer to justify the wages, and will have no trouble saying no to you if it doesn't seem legitimate. "It's usually the newer clients, and often the younger clients, who are watching these videos and then asking about it," says Mary McDonald, a CPA for Hansen House, based in Duluth, Minn.
McDonald has clients who successfully employ their own children and take a legitimate business income deduction for it. One such client has a construction business where they clear land and build houses. His 14-year-old works with him during summer, where the child is supervised, works reasonable hours and is paid less than somebody who would be more qualified. He makes about $6,000, so he gets experience and is able to make a full Roth IRA contribution, where the growth will be tax-free if he leaves it there until he's 59 1/2. As long as the child's earnings stay under the standard deduction, which is $13,850 for the 2023 tax year and $14,600 for the 2024 tax year, they will owe no income tax of their own. The parents get a deduction from this year's business income.
The thing is, that deduction will be for a limited amount, based on the reasonable amount of wages paid, and not a large sum that will erase all their business income or is just a convenient sum for the parent.
A lot of the social media pitch for this deduction strategy is actually less about saving money on taxes and more about them trying to sell their digital courses, Hall contends. "Marketers have figured out that If they can frame it in a way that makes people see this is super easy, they're going to buy my course and I'm going to make money," says Hall.
It's easy to see that paying $13,000 to an 8-year-old for what are basically household chores is out of bounds, but what about social-media influencers who put their kids in their videos and make money that way? Could you then justify a modeling fee for a baby?
"The first litmus test for hiring your kid is, would you hire a third party to do the same thing at the same hourly rate? if yes, then you can," says Hall. It is all the more legit, he adds, if you're actually selling a product that pertains to your child, like children's shoes. It's a bit harder if you run something like a lumber company, and post videos of your baby driving a truck.
"So modeling might be ordinary but it's probably not. And it's probably also not necessary for your business to function and make sales," says Hall.
You're also probably paying too much for the modeling involved. "People will do a photo shoot and they'll want to pay their kids like $5,000, but I'm pretty sure the Gerber baby doesn't even make that much money right now," Hall says.
What if you get caught?
If you claim wages for a child and get flagged by the IRS, you're first going to get a letter in the mail about an audit, which generally causes taxpayers to panic.
"They will likely disallow the expenses, so that will increase your profit, so you will need to amend the personal return. There's often a tax penalty and interest," says McDonald. She adds that the IRS often throws out a lot of other deductions when they start to poke around, so it's best to make sure everything on your return is justified.
Hall points to several tax cases where business owners lost on appeal and had wages for children disallowed. In one 2016 case, a marketing business owner paid his 10-year-old stepson $6,315 for wages that were labeled things like "taking out the trash, vacuuming, setting up chairs, and cleaning the pool." The taxpayer was dinged for a number of other disallowed deductions in the same case.
In a 2006 case, a family paid wages to five of their children, ranging in age from 8 to 21, for various tasks, but the IRS disallowed the deductions because the wages were not paid properly for necessary work. The oldest son, for one, was paid in advance for tasks he would do the following summer, more like an allowance than pay. The younger daughters were basically being paid for household tasks that weren't necessary for the business, and did not fill out proper W-2 paperwork.
"What happens is that everybody drastically overpays their kids and that exposes them to audit risk," says Hall. "When you tell people, yes, you probably could pay your kid $2,500 this year based on the scope of work that you've laid out, all of a sudden they lose interest because saving $1,000 in taxes is no longer that appealing, right? That's the piece that the TikTok and Instagram (META) gurus never really talk about."
