Kids payroll on S corp: disadvantages for small businesses

Susan Turcotte

• 03.12.24 • 5 min read

Hiring your children to work in your business might seem like the perfect strategy – offering tax savings while giving your kids valuable exposure to professional life. 

But when your business operates as an S corporation, this can become a minefield of tax and compliance challenges. S corps face strict rules regarding payroll taxes and requirements for family employees, leaving little room for tax benefits.

In this article, we'll explore the key pitfalls and disadvantages of employing your kids through an S corporation, including the complexities of alternate structures and administrative and compliance burdens. We'll also dive into IRS regulations and real-world cases to help you navigate kids' payroll on S corp disadvantages. 

What the IRS says about employing kids

The Internal Revenue Service (IRS) provides guidelines for hiring family members, including children, in your business. These rules vary based on the type of work kids perform.

For example, payments for simple tasks like babysitting or household chores are not subject to income tax withholding unless it's a domestic service job. They are also exempt from Social Security, Medicare taxes, and federal unemployment tax (FUTA) until the child turns 21.

The regulations also greatly vary depending on your business tax classification. 

The payments are subject to income tax withholding for children working in sole proprietorships or parent-owned partnerships. Social Security and Medicare taxes do not apply to children under 18, while FUTA taxes do not apply to children under 21.

For the rest of business tax statuses, including S corporations, the IRS states the following:

"If the business is a corporation, a partnership (unless each partner is a parent of the child), or an estate (even if it is the estate of the deceased parent of the child), payments for services of a child are subject to income tax withholding, social security taxes, Medicare taxes, and FUTA taxes regardless of age."

This means that payments to children working for an S corporation are fully taxable, with no exceptions for Social Security, Medicare, or FUTA taxes. 

Legitimate work and reasonable wages

If you choose to hire your child, their work must be legitimate, and their wages should be reasonable.

The tasks must align with your child's age and abilities. For example, simple clerical work might be appropriate if it provides real business value. You cannot create "dummy" work to justify having your kid on the payroll.

Also, the wages you pay your child for the work must reflect what you'd pay an unrelated worker for the same job.

Example:

An S corp owner running a small e-commerce business decided to involve his 6-year-old child in the company's social media activities. The child was featured in promotional materials, and the owner paid them $8,000 annually for modeling services. The intent was to showcase a family-friendly brand image while taking advantage of potential tax savings.

The IRS raised concerns about whether a 6-year-old could genuinely contribute to the business. Also, the agency questioned the child's involvement as legitimate work. The IRS found the $8,000 salary excessive for an inexperienced child model.

Complexities of alternate structures

Some small business owners explore alternative tax classifications like sole proprietorships or family management companies (FMCs) to work around S corp limitations. 

Before opting for an alternate entity, make sure that this election serves a real business purpose. Setting a sole proprietorship or an FMC solely to evade payroll taxes will attract the IRS's scrutiny.

Example:

An owner of a single-member LLC taxed as an S corporation operates an online business providing business coaching services. She hired her 14- and 15-year-old children to organize digital files and clean the home office.  Believing that switching to a sole proprietor would exempt their children's wages from Social Security and Medicare taxes, the entrepreneur hoped to reinvest those savings into the business. 

The business owner struggled to demonstrate the legitimacy of the sole proprietorship because the business structure and operations had remained the same. While the IRS does not explicitly ban such practices, tax courts have ruled against arrangements deemed abusive or lacking substance.

Alternate structures are not a guaranteed solution and may lead to significant scrutiny if they lack a solid foundation. Before pursuing this route, consult a tax professional to evaluate the risks and benefits.

Administrative and compliance burdens

Hiring children through an S corp introduces significant administrative and compliance challenges. These requirements can drain resources and create ongoing responsibilities for you as a business owner.

What to expect:

Payroll management: You must handle payroll processing, including issuing W-2s, withholding taxes, and managing Social Security, Medicare, and FUTA contributions.

Labor laws: Your kids' work in your business must comply with the Federal Fair Labor Standards Act (FLSA). Check guidelines for when and how long children can work and what tasks they can perform here. Note that state laws may impose stricter requirements. Always check state-specific regulations beforehand.

Hiring family members should align with your business's operational needs, not just tax goals. If it's not your case, explore other tax strategies.

Need help? Our expert CPAs will guide you through your options to ensure tax compliance and maximize your savings. From expert tax return preparation to entity structure optimization, you can rely on TFX for all your tax needs. Don't just take our word for it – check out what other small business owners have to say about our services.

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.