I own an LLC, of which I am currently the sole member. It's my main source of income.

I am wondering if there is a reason why I could not do the following:

  1. Hire my child as a part-time employee of the LLC, for an annual salary of $5500.
  2. Start a Roth IRA for the kid and put the $5500 into it.
  3. Deduct the $5500 as a payroll expense for my LLC, thereby reducing my amount of taxable income.

To me, this seems attractive because I'd lower my LLC's tax liability. Meanwhile, my kid would not have to pay any taxes on the $5500 because it is lower than the standard deduction. And by putting the money in a Roth IRA, he'd get an investment that would grow tax-free. It would essentially be like getting the pre-tax benefits of a traditional IRA with the post-tax benefits of a Roth.

The way I see it, I'd win, my kid would win and the IRS would lose, for once.

Is there any reason this wouldn't work? There is no minimum age or income for contributing to a Roth IRA. So as long as I could legally hire my kid, I don't see any obstacles.

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    Obvious question. How old is your kid, and what would he/she be doing to earn this money? Because the IRS will want to know. – DJClayworth Apr 8 at 23:25
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    In this scenario, would your kid be doing work worth a FMV of $5,500 or would it be an admitted sham just for the tax benefits, or something in between? – Patrick87 Apr 8 at 23:27
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    Note that you would have to pay payroll taxes on the salary, even though it's not enough to trigger ordinary income tax. – chrylis Apr 9 at 2:58
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    @reirab It still is the case for the child's pay--either it's self-employment, or it's employment. – chrylis Apr 9 at 17:37
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    Important note regarding this: The standard deduction for single taxpayers is $12,000 for 2018, thanks to last year's tax cut bill. Edit: If you can be claimed as a dependent, the standard deduction is only $1,050, so apparently they anticipated this. :) – reirab Apr 9 at 20:35

Forget the Roth for one moment.

Having a $5500 deduction for your LLC would be great. Parents hire their kids all the time. To do real work at a reasonable wage. Do you have work that's appropriate for the child and would it pass the duck test*? If not, don't do it. (per a request via comment - A duck test - "Is the work real and substantial enough that the the wage you are paying is what you'd be willing to pay a neighbor's kid, or any other kid, to do?" This is what I had in mind)

If you answered yes to the above, the Roth is a great account for the kid's money.

Disclosure - when my daughter was 11 and earning money babysitting, I offered her a deal. Keep notes on your sitting money. Name, date, amount. At the end of the year, I will give you an equal amount, deposited to a Roth IRA. She is a freshman in college, and already has $25K in her retirement account.

On reflection, and prompted by a comment, there are a few more things to consider. While the annual Roth limit is $5500, the standard deduction (in 2018) for your child is $12,000. This offers a larger opportunity to deposit to a college savings account, effectively deducting another $6500 from your income and putting it aside for a good cause. If you use a 529 account, the growth will also be tax free. A winning combination. And the only warning, be sure the pay is justified. Above $12K, and the child would start to see a tax due.

Regarding payroll tax, mentioned by a member comment on question, from the Forbes article See The IRS's Incredibly Generous Tax Benefits For Hiring Your Own Child

You don’t have to pay payroll taxes for employing your kids if your business is a sole-proprietorship, a single-member LLC taxed as a disregarded entity, or an LLC taxed as a partnership and owned solely by you and your spouse.

*If it walks like a duck and quacks like a duck, it's likely a duck.

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    I worked for my dad doing menial labor for his small business over the summer, when I was in high school. He gave me the option to get paychecks for the work at a rate equal to minimum wage [totaling about 2,000 over the whole summer] or have 5,000 deposited into a Roth IRA. I chose the Roth IRA for multiple years. When I went off to college I got a scholarship, but still did 5k worth of labor, just to keep contributing. Now with 100k in my IRA by the end of graduate school, it feels really nice. That one choice my dad gave me led to a lifelong lesson in investing for the future. – WetlabStudent Apr 9 at 12:26
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    A short example of something that fails or passes the duck test would be helpful. I think I understand what you're getting at with that bit, but not 100%. – BlackThorn Apr 9 at 16:19
  • How would one calculate the % error for the duck test? ;) – dalearn Apr 9 at 17:12
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    @dalearn by measuring the % of mallards in the target sample compared to the standard deviation. – Mindwin Apr 9 at 18:27
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    I opened a Roth IRA when I was 14. My parents do not have college degrees and no investing experience so I talked to my grandparents and they bought me some books on investing. I just graduated college and still contribute to my Roth when I can. It’s worth like $12,000 right now. I opened it with $100 I made at my first job washing dishes. I contributed to it monthly until I went to college, then stopped Monthly because I didn’t work in college, was on full ride academic and had negative free time let alone time to work. My parents had to co-sign the account since I was under 18 – Prince M Apr 10 at 0:59

Your child will pay state and federal taxes on the $5500. You could setup a Simple plan and then only pay state. You don't have to pay payroll taxes but the earner still has to pay tax on their income.

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    If you earn less than $10,400 you don't have to pay income tax. – Barmar Apr 9 at 15:51
  • @Barmar what if someone (parent) claims you as their dependent, and therefore you can not get an exemption for yourself? – DavePhD Apr 9 at 16:55
  • From turbotax.intuit.com/tax-tips/family/… - If they earned less than $6,350 in 2017, they do not have to file a return, but may wish to do so to recover any withheld income taxes. – Barmar Apr 9 at 16:59
  • @DavePhD He's talking about standard deduction. Exemptions go away for 2018 anyway. But the standard deduction roughly doubled, making this an even more viable strategy than before. – reirab Apr 9 at 20:32
  • @Barmar For federal. States can - and frequently do - have different limits. My daughter had to file state but not federal last year, and got a full refund of federal this year but had to pay a small amount in state taxes. – GalacticCowboy Apr 10 at 11:48

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