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Sole Proprietors & Employing Your Children

As a sole proprietor, you can operate a business without having to deal with the formalities of creating a separate legal entity, such as a corporation or limited liability company, and still hire employees — even if they are your children. However, there are a number of federal tax implications you need to consider when you hire your children as employees.

Deducting Child’s Salary on Schedule C

One advantage you have as a sole proprietor is that you can deduct all employee compensation from your sole proprietor earnings. In order to deduct employee salaries, the IRS requires that they be reasonable in amount. When employing your children, this “reasonable in amount” becomes extremely important. Generally, when evaluating whether the compensation is reasonable, you must consider a number of factors such as the skills your children offer, the amount of time they dedicate to the employment and the complexity of the tasks they are responsible for. For example, if your children are teenagers and work approximately 15 hours per week performing general office work, compensating each of them with a $2,000 weekly paycheck can be deemed unreasonable by the IRS.

Tax Withholding & W-2 Filing

You must always consider whether it’s necessary to withhold federal income taxes from your children’s wages. Each child must provide you with a W-4 to make this determination, though in some cases, the W-4 may reveal that they are exempt from withholding. As an employer, you also have an obligation to withhold Social Security and Medicare taxes from their wages. However, for your children who are under the age of 18, the IRS doesn’t require you to withhold these taxes. At the close of each tax year, you need to prepare a W-2 form for each child you employ. The W-2 will report their annual salary and all taxes you withhold during the year. So that your children can prepare their tax returns, the IRS requires that you furnish each of them a copy of the W-2 by January 31 of the following year. You must also send a copy of each W-2 to the Social Security Administration — not the IRS.

Paying Employment Taxes

Sole proprietors with employees are also responsible for paying employment taxes — which is unrelated to the taxes you withhold from their salaries. If it’s necessary to withhold Social Security and Medicare taxes from your children’s paychecks, you then have an obligation to pay an additional amount from your own funds that, in most tax years, is equal to the amount your children pay through withholding. You also have a responsibility to make payments from your own funds for federal unemployment taxes for any children under the age of 21.

Filing Schedule C

When you prepare your Schedule C to report your business income and expenses, the IRS does allow you to deduct many of the expenses you incur that relate to your employee children. In addition to a deduction for their salaries, you can also deduct the Social Security and Medicare taxes you match as well as all federal unemployment taxes.

IRS Reference: Publication 15 – (Circular E), Employer’s Tax Guide