Shift income to your kids, tax-free

Wouldn’t it be nice if income were tax-free? It can be — if you’re self-employed and have kids who work in your business. Self-employment enables you to shift a portion of your income to your children completely tax-free, something traditional W-2 employees cannot do.

How it works

Sole proprietors are allowed to pay their children (under age 18) wages that are not subject to Social Security and Medicare taxes. Also, their children’s wages up to $6,300 (as of 2015) are income-tax-free, courtesy of the standard deduction. As long as you don’t pay them more than the standard deduction, those wages are completely tax-free. So you can shield $6,300 per child from taxes. If you’re in, say, a 33% combined federal and state marginal tax bracket, that’s a savings of $2,079 per child (33% of $6,300).

If your business is taxed as an S corporation, this income-shifting tactic becomes a little more complicated. You must set up a separate business as a sole proprietorship to serve as a “family management company” or FMC. You’ll also need to open a separate bank account for the FMC. Your S corp will pay the FMC a management fee that totals a little more than the amount of your children’s wages. The FMC will then pay the children’s wages out of that fee.

Using your child’s wages

When shifting income to your children, keep in mind that the money becomes theirincome, so how you use it may be restricted to a degree by the IRS. In general, a child’s wages are under the parents’ control However, the IRS expects parents to supply certain things for their children, like food, shelter, and clothing, so using their wages to pay for such things wouldn’t be appropriate.

Identify other expenses — things you would have spent money on anyway — that can be paid with your children’s income, such as  vacations, summer camp, music lessons, video games and so on. Also, if your children receive an allowance, you can include that as a portion of the income they earn, effectively making it a tax-deductible expense.

Alternatively, the money could go into a Roth IRA in your child’s name. The reason I recommend a Roth IRA is that contributions (though not earnings) can be withdrawn at any time tax-free. So if you contribute $5,000 a year for five years, your child can withdraw $25,000 tax-free to use for college, a car or anything else. As an added bonus, any remaining contributions could be used to jump-start your child’s retirement savings.

Multiple benefits

Not only can this potentially save you thousands of dollars on your taxes, but it also lowers your taxable income, since the wages paid to your children are a deductible business expense. And the whole endeavor teaches your children the value of work and the benefits of saving and preparing for the future.

There is a certain amount of compliance you need to follow to take advantage of this strategy, which is why I recommend you consult with a tax professional before moving forward with shifting income to your children.

Learn more about Brock on NerdWallet’s Ask an Advisor.