Hiring Children in the Family Business: § 3121(b)(3)(A) and the Documentation That Holds Up

Wages paid to a taxpayer's child employed in the parent's trade or business are deductible under § 162 if (i) services are actually rendered, (ii) the compensation is reasonable for the services, and (iii) the work is age-appropriate. § 73 treats amounts received for the services of a child as the child's gross income (not the parent's), shifting the wage into the child's bracket.

The payroll-tax exceptions

§ 3121(b)(3)(A) excludes from the definition of "employment" (and therefore from FICA) services performed by a child under age 18 in the employ of the child's parent, or in a partnership consisting only of the child's parents. § 3306(c)(5) provides the parallel FUTA exception for a child under age 21. Federal income tax withholding still applies under § 3401, but the child's wages are typically well within the § 63(c) standard deduction.

The entity-form trap

The § 3121(b)(3)(A) FICA exception is unavailable if the employer is a corporation (S or C), a partnership with any partner other than the parents, or an estate. For an S-corp owner who wants the payroll-tax break, the standard solution is to operate a separate sole proprietorship (or husband-wife partnership) that hires the child and contracts services to the S-corp. The sole prop's contract revenue offsets the wages; the S-corp gets the services it needs; the payroll-tax exception survives.

The reasonable-compensation analysis

The IRS attacks unreasonable family wages under § 162(a)(1) as not "ordinary and necessary" and the regulations under § 1.162-7. The key Tax Court cases (Eller v. Commr., Denman v. Commr., Bly v. Commr.) turn on:

• Bona fide services. Real work performed, age-appropriate, documented contemporaneously.
• Comparability. Wage rate aligned with what an arm's-length employer would pay for the same work, considering experience and locality.
• Form. Same payroll mechanics as any other employee — written job description, timesheets, payroll register, W-2 issued, wages paid into an account controlled by the child.

Collateral planning

• Roth funding. The wage is earned income, eligible for full Roth IRA contribution up to the lesser of compensation or the annual limit. § 73's assignment-of-income treatment does not impair the contribution.
• Standard deduction. § 63(c)(5) caps a dependent's standard deduction at the greater of $1,300 or earned income plus $450 (2025 figures), but not more than the regular standard deduction. Earned wages up to the regular standard deduction are federal-income-tax-free.
• Kiddie tax. § 1(g) applies only to unearned income. Earned wages are not subject to kiddie-tax rates.
• State payroll taxes. The federal FICA/FUTA exceptions do not automatically flow through to state payroll taxes or workers' compensation; check state rules.
• Form W-2. Issue even when no tax is withheld. § 6051 reporting is required.