Hiring kids for a rental LLC

Tax, SDIRAs & Cost Segregation
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Hiring kids for a rental LLC

Jane Z.
GA · Member since 2011 · 62 posts · 6 votes

Hi,

I have several children related tax question. After consulting with my CPA, I am now confused. Here is my situation.

My husband and I set up a rental LLC several years ago. The same CPA told us since only my husband and I owned the LLC, we should file Schedule E on our tax return. So that is what we have been doing. Lately we are considering hiring my two kids, who are under 18 years old, for some office work, such as setting up a rental website, mowing lawn, bookkeeping, etc. The CPA told us since we file our rental income using Schedule E, our rental properties will be considered as an investment. Unless our rental LLC is considered as a business, my kid income will subject to social security tax and Medicare tax, although not income tax if it is under $6300. Since we manage our rental properties ourselves, I told him our rental LLC should be considered as a business. In that case, the CPA said, we should file Schedule C instead of Schedule E and pay self-employment tax. Then I ask the CPA could I pay my kids to set up a rental website just like we pay a plumber to fix a toilet? My CPA then said yes, in his words, ‘There is no difference on your side to pay them vs to pay a plumber. There is no difference on their side to earn from working for you vs working for others.' Here is my confusion. If we pay my kids to set up a website and deduct those expense as rental expense, what kind of tax my kids need to pay? Do they need to file a separate tax return? Or what is the best tax strategy in this scenario? I feel I have asked my CPA too many questions and want to see how other people handle this.

Thanks a lot for help.

Jane

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Karolis Matulis
Accountant · Cranford, NJ · Member since 2016 · 34 posts · 22 votes
10y

How much are you looking to pay them over the course of a tax year? The pitfalls of these kind of scenarios is generally proving to the IRS that the payment was for actual work done. The easiest way to make this work is to treat the kids as contractors. Have them perform specific tasks and issue invoices that the LLC would pay. This would leave a paper trail and a record of work actually done. Everything needs to be reasonable and payment/cost needs to be similar to what you would see in an arms-length transaction with an unrelated party.

At the end of the year you'll need to issue 1099-MISC to both kids for the total payments through the year. They will have to file individual 1040 returns and report that income. The income will be subject to the self-employment tax (medicare and social security) as well as income tax (they can claim expenses if there were any in them performing their services). 

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  • Karolis Matulis
    Accountant · Cranford, NJ · Member since 2016 · 34 posts · 22 votes
    10y

    How much are you looking to pay them over the course of a tax year? The pitfalls of these kind of scenarios is generally proving to the IRS that the payment was for actual work done. The easiest way to make this work is to treat the kids as contractors. Have them perform specific tasks and issue invoices that the LLC would pay. This would leave a paper trail and a record of work actually done. Everything needs to be reasonable and payment/cost needs to be similar to what you would see in an arms-length transaction with an unrelated party.

    At the end of the year you'll need to issue 1099-MISC to both kids for the total payments through the year. They will have to file individual 1040 returns and report that income. The income will be subject to the self-employment tax (medicare and social security) as well as income tax (they can claim expenses if there were any in them performing their services). 

    4Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    Hi Karolis,

    Thank you so much for your detailed explanation. I think I will pay them no more than $5000 per tax year. Looks like you and my CPA are on the same page. Part of my confusion comes from a book called 'Every Landlord's Tax Deduction Guide'. I bought this book in early 2014. In this book, it said we could use Schedule E for both investment and business purpose. It also said we could hire kids as an employee to avoid self-employment tax. Then I found what the book said is different from what my CPA told me. The CPA actually does not do our income tax. I have been doing it myself. He only does tax for my husband's business and my income tax consultant occasionally. I have suggested him a couple of times that maybe it is better for him to do our income tax. But he told me that would be a waste of time and money because he is using the same software as I did. Other than depreciation and standard deduction, not much else he could do. But the book seems having a lot of tricks. The other thing the book mentioned, but I never follow, is the home office deduction. Somehow, when I added the home office deduction, my tax is even more, not less. Originally I trust all the information in the book. Right now I wonder whether this book is too aggressive on some deductions. 

    Thanks.

    Jane 

    0Reply
  • Karolis Matulis
    Accountant · Cranford, NJ · Member since 2016 · 34 posts · 22 votes
    10y

    Schedule E is the right place for rental income/expenses. Pure rental activity is considered to be passive by the IRS. As such Schedule E does not even provide a line for wages/compensation (employees), the implication is a passive activity cannot have employees. This does not preclude you from having contractors perform work when necessary and bill you on a per job basis (what your sons would be doing). 

    The home office deduction is a popular deduction that people try and be aggressive with but in my experience it is extremely difficult for people to qualify for when everything is done by the book. There is a significant amount of rules and case law that make it very difficult to pass IRS scrutiny in that regard. 

    0Reply
  • Michael Totman
    Real Estate Agent · Berlin, MA · Member since 2013 · 130 posts · 95 votes
    10y

    "....I read a book once that told me to do this...." words to live by, and also words to die by.  I always wonder who those authors are, what year was the book written, and from what tax jurisdiction.  Sometimes they are accurate, sometimes not, but nothing can substitute for real life professional advice...

    0Reply
  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    10y

    I can't comment on SE taxes for employees, (my kids are young and I pay them less than the magic $600/yr each) but shouldn't you be filing a 1065 for the LLC and an 8825 for the rentals instead of a Sch E? The 8825 will be the bulk of what generates the K-1 that passes through to your 1040.

    I've been filing my own LLC returns for 11 years and have never done a Sch E with those assets. Glad you have a CPA, @Jane Z.  Hopefully you're ok!

    0Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    Thanks a lot. I really appreciate it. I feel much clear now.  Lately I have been trying to find a good CPA who maybe understand what the book said. I guess I will stick with my current one now. Thanks.

    0Reply
  • David Dachtera
    Rental Property Investor · Rockford, IL · Member since 2014 · 4k+ posts · 2k+ votes
    10y

    @Jane Z.,

    Wow! You REALLY need to talk to my investing group's JD/CPA tax attorney/accountant!

    What are you doing this Saturday that you can't get out of, and can you manage a trip to suburban Chicago? He's here this weekend for actually two days: Friday p.m. from 3 to 6 he'll be talking about using QuickBooks in your REI business and Saturday from 9am to 5pm he'll be talking about building your entity structures for tax advantage, asset protection and estate planning, including how to pay your minor children without also having to pay SUTA, FUTA, FICA, etc. for them.

    I can't do this justice not being a legal / financial professional, but from what I remember, you DO NOT WANT to pay them out of an S-Corp or an LLC. You'll need a "Z. Family Management" company or similar set up as a sole-proprietor. The money for the kids then flows from the S-Corp to the SP and thence to the kids. I can refer you to his law / accounting firm, if you like.

    0Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    @Michael Totman The book was written for tax year 2014, which I used to prepare for my 2014 income tax. So at the time it was not a out-of-date version.

    @Steve Vaughan I think the magic number for SE tax threshold is $400, not $600. $600 is the threshold for 1099-Misc. Based on my understanding now,  in theory, if you pay your kids $599,  you kids could still face SE tax obligation even if you don't give them 1099-Misc. @Karolis Matulis Could you please clarify this?

    Thanks.

    0Reply
  • Karolis Matulis
    Accountant · Cranford, NJ · Member since 2016 · 34 posts · 22 votes
    10y

    Jane you are correct in saying that $600 is the magic number for issuing a 1099-misc and that $400 is the magic number for SE tax. 

    If the kids pitch in and both do $1000 amount of work and have no other income they will likely not have any income tax due. The amounts are below the standard deduction for both and their tax return will only reflect the SE tax. With some planning, depending on their other income and dependency status you could pay them quite a bit more and not generate any income tax. Some level of SE tax (should be around 14.x% at such income levels) is largely unavoidable without business expenses on their end. 

    2Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    @Karolis Matulis   Thank you so much for the confirmation. I believe the threshold for income tax in 2015 is $6300. Since my kids are still very young, I don't think I could pay them that much unless they are Bill Gates and really build me a fancy website. We are currently taxed at 25% income tax level, 14% sounds a much better choice. Suppose we pay them $399 each, do we need to report this amount anywhere? Or it is still a good idea to file their tax return separately so that I could clearly deduct these $798 as my rental expense? Will filing their tax return separately negatively affect our own income tax or it will have no effect? Sorry I have so many questions.

    Thanks.

    Jane

    0Reply
  • Karolis Matulis
    Accountant · Cranford, NJ · Member since 2016 · 34 posts · 22 votes
    10y

    The $6300 figure you cited is right for single taxpayers who cannot be claimed as dependents. Because you claim your kids as dependents they do not get the full $6300 standard deduction. The math gets a bit more complicated to calculate the adjusted deduction but the minimum is $1050 (scaling up with earned income). 

    As for your second question if you pay them $399 each and have invoices from them supporting the work performed (and the payment is reasonable for that work) you do not have to file anything on their behalf. They fall under the $400 SE income threshold for filing and do not require tax returns. The invoices will be the substantiation for the $798 expense on the rental just like any other arms-length invoice. 

    1Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    @Steve Vaughan Thank you so much for pointing out my $6300 figure is not correct.  I have learned so much on BiggerPockets because of people like you. 

    0Reply
  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    10y

    Suggest you don't pay your kids directly. Instead, open a Roth IRA for each child and deposit their income directly into the IRAs.

    0Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    @Dave Toelkes Thank you for the suggestion. I had planned to open both custodial accounts and Roth IRA for them, then pay them through online payment from our business account to their custodial accounts, then transfer the money into their Roth IRA accounts. If you think custodial account is not necessary from tax prospective, I will be very glad to drop them.

    1Reply
  • Jason M.
    Investor · Jupiter, FL · Member since 2016 · 26 posts · 7 votes
    10y
    You would have a very hard time convincing the IRS that your children are independent contractors. Be very careful. Look up the rules, they are very clear in this instance.
    0Reply
  • Jane Z.
    OP
    GA · Member since 2011 · 62 posts · 6 votes
    10y

    If we need to hire someone to mow the rental properties lawns or maintain websites, I am not sure why it will be very hard to convince IRS that we could hire our own kids to do the job if they are capable, and their payment is reasonable for their age.  

    0Reply
  • Jessika Wray
    Member since 2020 · 2 posts · 0 votes
    2y
    Quote from @Jane Z.:

    Hi Karolis,

    Thank you so much for your detailed explanation. I think I will pay them no more than $5000 per tax year. Looks like you and my CPA are on the same page. Part of my confusion comes from a book called 'Every Landlord's Tax Deduction Guide'. I bought this book in early 2014. In this book, it said we could use Schedule E for both investment and business purpose. It also said we could hire kids as an employee to avoid self-employment tax. Then I found what the book said is different from what my CPA told me. The CPA actually does not do our income tax. I have been doing it myself. He only does tax for my husband's business and my income tax consultant occasionally. I have suggested him a couple of times that maybe it is better for him to do our income tax. But he told me that would be a waste of time and money because he is using the same software as I did. Other than depreciation and standard deduction, not much else he could do. But the book seems having a lot of tricks. The other thing the book mentioned, but I never follow, is the home office deduction. Somehow, when I added the home office deduction, my tax is even more, not less. Originally I trust all the information in the book. Right now I wonder whether this book is too aggressive on some deductions. 

    Thanks.

    Jane 

    We are navigating the same situation.  What I’ve found is opening a ‘Family Management LLC’ and hiring your children as W2 employees.  From here you would expense your Sechdule E for work performed as you would any other repair or maintenance work, this time paid to your family management LLC.  The LLC files a schedule C at the end of the year and all money in and is wash as it’s paid out to employees.   no profit.  This avoids SE taxes on your end and their end as they are W2 employees not 1099.  Minors are not subject to FICA if paid through parents owned partnership or sole prop. 
    0Reply
  • Stacie Ngo
    Member since 2022 · 1 post · 0 votes
    2y
    Quote from @David Dachtera:

    @Jane Z.,

    Wow! You REALLY need to talk to my investing group's JD/CPA tax attorney/accountant!

    What are you doing this Saturday that you can't get out of, and can you manage a trip to suburban Chicago? He's here this weekend for actually two days: Friday p.m. from 3 to 6 he'll be talking about using QuickBooks in your REI business and Saturday from 9am to 5pm he'll be talking about building your entity structures for tax advantage, asset protection and estate planning, including how to pay your minor children without also having to pay SUTA, FUTA, FICA, etc. for them.

    I can't do this justice not being a legal / financial professional, but from what I remember, you DO NOT WANT to pay them out of an S-Corp or an LLC. You'll need a "Z. Family Management" company or similar set up as a sole-proprietor. The money for the kids then flows from the S-Corp to the SP and thence to the kids. I can refer you to his law / accounting firm, if you like.


     Who did you use to complete the structure? 

    0Reply
  • Account Closed
    Accountant · San Diego, CA · Member since 2019 · 1k+ posts · 552 votes
    2y
    Quote from @Stacie Ngo:
    Quote from @David Dachtera:

    @Jane Z.,

    Wow! You REALLY need to talk to my investing group's JD/CPA tax attorney/accountant!

    What are you doing this Saturday that you can't get out of, and can you manage a trip to suburban Chicago? He's here this weekend for actually two days: Friday p.m. from 3 to 6 he'll be talking about using QuickBooks in your REI business and Saturday from 9am to 5pm he'll be talking about building your entity structures for tax advantage, asset protection and estate planning, including how to pay your minor children without also having to pay SUTA, FUTA, FICA, etc. for them.

    I can't do this justice not being a legal / financial professional, but from what I remember, you DO NOT WANT to pay them out of an S-Corp or an LLC. You'll need a "Z. Family Management" company or similar set up as a sole-proprietor. The money for the kids then flows from the S-Corp to the SP and thence to the kids. I can refer you to his law / accounting firm, if you like.


     Who did you use to complete the structure? 


     We cannot promote ourselves on BP as it is against the rules,

    In the original poster's situation, the kids should not have to pay any taxes as long as the income is below the 13,850 limit for 2024. Our clients issue w2s directly to their kids and follow a similar structure as the one mentioned above with the hold co and have had success doing this "pay your kids" strategy. Best of luck! 

    0Reply
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