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Wouldn鈥檛 it be nice if income were tax-free? It can be 鈥� if you鈥檙e聽聽and have kids who work in your business. Self-employment enables you to shift a portion聽of聽your income聽to聽your聽children completely tax-free, something traditional W-2 employees cannot do.

How聽it works

Sole proprietors聽are allowed聽to pay聽their聽children (under聽age聽18) wages聽that聽are聽not subject聽to Social Security聽and Medicare taxes.聽Also,聽their children鈥檚 wages up to $6,300 (as of 2015) are income-tax-free, courtesy of the standard deduction. As long as you don鈥檛 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鈥檙e in, say, a 33% combined federal and state marginal tax bracket, that鈥檚 a savings of $2,079 per child (33% of $6,300).

If your business is taxed as an聽,聽this income-shifting tactic becomes a little聽more complicated. You聽must set up a separate business as a sole聽proprietorship to serve聽as a 鈥渇amily management company鈥� or FMC. You鈥檒l also need to open a separate bank account for the FMC.聽Your S corp will pay the FMC a management fee that totals a little more than the amount of your children鈥檚 wages. The FMC will then pay the children鈥檚 wages out of that fee.

Using your child鈥檚 wages

When shifting income to your children, keep in mind that the money becomes聽theirincome, so how you use it may be restricted to a degree by the IRS. In general, a child鈥檚 wages are under the parents鈥� control However, the IRS expects聽parents to supply certain things for their children, like food, shelter, and clothing, so using their wages to pay for such things wouldn鈥檛 be appropriate.

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

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go into a聽in聽your child鈥檚聽name.聽The reason I recommend a Roth IRA is聽that contributions (though not earnings) can be withdrawn at any time tax-free.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

Learn more about Brock on NerdWallet鈥檚聽.