With everyone jumping back into the school season, there is plenty of money in motion this month. Tuition, supplies, clothes, sports, and the dozens of other expenses to support our children can add up quickly. If private school or college is involved, some families easily add another $10-20k per child in expenses. From a financial perspective, is there a better way to manage these expenses? Possibly. Business owners have a unique situation where they could save thousands of dollars in taxes by rerouting who is paying for all of these expenses.
What are You Currently Doing?
Kids are certainly one of the greatest blessings in the world. My daughter has changed my life in more ways than I could imagine. Even as the “money guy” in the family, I get surprised at the price of something related to her. This past week was the first day of school, and we have the privilege (and significant expense) of sending her to a local private preschool. Whether it’s preschool, grade school, or college, you don’t have to look far to see how expensive education can be.
According to the Education Data Initiative, the average cost of in-state tuition in Kentucky is $11,107, which jumps to $27,553 if you add room and board. Over 4 years, that’s over $100,000 for a public university education. For those of us with younger children, the costs start even earlier, with a monthly average of daycare/preschool running upwards of $800-$1,200 per month. Private and even public education for our kids can get expensive.
Is this similar to your situation? Using your current cash flow to cover tuition can swing the bank account dramatically every August. But here is where we could start making changes. The money coming out of your bank account is “post-tax” money since you likely already paid income tax on those dollars as earnings of the company. If we assume you had a 30% tax rate and school costs $12,000, then you likely had to profit $17,142 to be able to take home and pay $12,000. Instead of pulling the earnings out of the business, it could be possible to hire and pay your kids directly, hopefully at a 0% tax rate.
Hire Your Kids Into the Family Business
To figure out if hiring your kids could work, there are a few important variables to consider. First, is the age and development of your children. They should take on responsibilities that match their maturity level. Using common sense will go a long way here. Regulators would ask more questions if a 3-year-old is doing the books versus a 17-year-old. The amount paid needs to be reasonable and not too excessive, given the level of work in the business.
The second variable is the structure of the business. Sole proprietors or parents in a partnership are the best fit for this tax-saving strategy. If that is the case, as long as you pay your child less than the $14,600 standard deduction (in 2024), they could likely receive all of the income tax-free. On top of that, if they are under age 18, they are exempt from Social Security and Medicare taxes. Rules do change for corporations and partnerships where all partners are not the parents of the child, and the IRS website breaks down these differences.
Let’s look at an example for context. Let’s say the Smiths have three kids, ages 11, 10, and 8. All three kids are mature enough to help in the family business. This could be anything from marketing assistance to cleaning services. Since the Smiths own the business themselves, they can pay each kid an appropriate wage, say $12,000 a year, totaling $36,000.
Wages are deductible to the business, so the Smiths now have $36,000 less that they must pay taxes on. If the Smiths had a 30% tax rate, then a $36,000 deduction would reduce their taxes by $10,800. Additionally, the Smiths also would have had to pay self-employment tax for that $36,000. At 15.3%, that is another $5,508 saved in taxes. So just by hiring their kids, the Smiths would save $16,308 in taxes on the $36,000 they were already going to spend on their kids anyway.
Create Wealth for You and Your Kids
This strategy works because each child is hired as a W-2 employee and paid directly. Importantly this does not have to be a one-time opportunity. In our example, the oldest kid has another 7 years until they turn 18. As long as they can work, the Smiths could save $16,308 each year, totaling over $110,000 in taxes over the next 7 years. Business owners can benefit from the additional tax savings, and ultimately pay for education out of the kid’s account instead of theirs.
There are many additional planning opportunities for owners and their children to grow their wealth as well. Parents do not have to spend the entire salary of each child. When that is the case, they have essentially created a savings vehicle. This approach doesn’t need to be complex but should align with your long-term goals for your children. For instance, if you are comfortable paying for grade school now, you could save the excess for college in later years.
It’s also possible to start creating generational wealth. The earlier anyone starts contributing to a retirement account, the better. For example, if a child contributes $5,000 annually to a Roth IRA from age 10 until they turn 18, they would contribute $35,000. If they left the money untouched until age 65, the account could grow to $1.98 million, assuming an 8% annual return1. The result is nearly $2 million completely tax-free. Imagine having an additional $2 million tax-free in retirement—what would you do?
What is Most Important to You?
Chances are, if I asked you what is most important to you, your kids would be one of your first responses. There are ways, if you are intentional, to not only save thousands of dollars in taxes but also create generational wealth for your family. Work with a tax professional and a financial planner to see if this strategy works for you. Getting your kids started early in the family business is an excellent way to teach foundational skills. Who doesn’t want to save money and build a better life for their children?
1This is a hypothetical scenario and intended for educational purposes only. It does not represent an actual client, investment or experience, but rather meant to provide an example of the intended investment process and methodology. An individual’s experience may vary widely based on his or her circumstances.
TC Falkner 