Paul Neiffer, The Farm CPA, grew up on a farm, plowing fields, harvesting crops and driving trucks. When he turned 17, his parents rewarded him for his labor by buying him and his brother a car.
Neiffer now knows that his parents "messed up." They probably would have been better off paying him an annual wage, starting at about age 13, and putting it in a retirement account. Sole proprietors, and partnerships in some cases, can pay their children under 18 up to about $6,000 a year tax-free under federal tax law (state law may be a little different.)
Not only are the kids’ wages not subject to income tax, but the parent, if set up as a sole proprietor, doesn’t have to pay payroll taxes—FICA, Medicare and possibly unemployment taxes.
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"My parents could have paid my brother and me $6,000 apiece," Neiffer says. "We wouldn’t owe any income taxes. We could take that earned income and put it in a Roth IRA. If we did that for six years and let it compound at a good rate of return, when we are 60 or 65 years old, that Roth IRA could easily be worth $500,000 or more."
The key, Neiffer says half joking, is to never tell your kids about the money in the Roth IRA, or they might spend it. "Wait until they see it in your will," he says.
How old must your children be before you pay them a wage? That depends on state child labor laws.
"Typically, you can’t pay wages to a 2-year-old, even one that’s riding in the cab every day during harvest," Neiffer says. "But you may be able to pay an 8-to-10-year-old, depending on the law. In other states, you may not be able to hire a child under 14."
If parents elect to pay their child a wage, it’s important to keep good paperwork. "You want to document that they did something that’s reasonable," he says.
Neiffer also recommends that parents take advantage of making gifts to their children. Farm commodities make a nice gift. That strategy effectively reduces the farmer’s income. Depending on the size of the gift, the child might not owe any taxes on it. And self-employment taxes can sometimes be reduced by the gift amount.
Here’s how it works. Say you gift 1,000 bu. of corn to each child. You have removed at today’s prices about $5,000 in income on which you would otherwise pay at least a 15% tax, plus up to 15.3% in self-employment taxes, plus related state income taxes. The child, when he or she sells the corn, might not have to pay tax on it. However, the "kiddie tax" might require some taxation but will eliminate any self-employment tax.
Farmers can gift their children up to $14,000 each year without having to file a gift tax return. "You can pay for their college tuition directly," Neiffer says. "And you can pay for all their medical costs." None of these items count toward the $14,000 annual limit.
How much can you pay your kids? Minimum wage laws provide a convenient floor. If kids work 1,000 hours during the year at a minimum wage of almost $10 an hour, they would earn $10,000. They might have some tax liability at that income level, but they would be in the lowest tax bracket.
"So as a family, you probably pay less in tax," Neiffer says.