Can your children help out with some of the chores connected with your business? Then a savvy way to take care of their allowances or spending money–at the expense of the Internal Revenue Service–is to pay them wages for the work they do.

Going that route is not just a strategy to save taxes for the family as a unit. It provides your children with jobs that put some “jingle in their jeans,” familiarizes them with the business, and instills a bit of the old work ethic. Here are several strategies to keep in mind when your business pays them compensation that it deducts and they report on their returns.

Staying Clear of “Kiddie Taxes”

Putting your children on the payroll is a perfectly legal way to keep income in the family, but shift some out of your higher tax bracket and into their lower bracket. This maneuver is not crimped by “kiddie tax” rules that curtail the ability of parents to shelter investment income by gifts to their children of cash, stocks, and other income-generating assets.

Under these rules, dividends, interest, capital gains, and other kinds of investment income received by a child 14 or older get dunned for taxes at the child’s, not the parent’s, rate. However this sort of income received by a child under the age of 14 is generally taxed at the parent’s top rate when it exceeds a specified figure ($1,500 for 2003), which is indexed–that is, adjusted annually to reflect inflation, as measured by increases in the Consumer Price Index.

Although the point is often overlooked, the kiddie tax restrictions are not applicable to children’s wages, whether those wages come from baby-sitting, delivering newspapers, or even working for a business owned by a parent. The business gets to deduct the wages, which are taxed to the child at the child’s own rate. Consequently, it might prove more advantageous to pay wages to an under-14 child than to bestow properties on the child that generate an identical amount in income.

The child can offset income with a standard deduction, the no-questions-asked amount authorized for a person who doesn’t itemize. For 2003, the standard deduction is capped at just $750 for investment income but tops out at $4,750 for wages and other kinds of earned income. So the more income the child receives as wages, the more that escapes taxes, thanks to the standard deduction, which also is indexed.

Caution: Unsurprisingly, the IRS bars any deductions for the value of meals and lodgings you furnish. As a parent, you are legally obligated to support your children.

The Way It Works

Imagine that your business hires Nadine, your 17-year-old daughter, to do clerical work after school, on weekends, and during school vacations. For 2003, you pay her $4,750, which Nadine can use to support herself or put away for college, a wedding, a car, or a post-graduation vacation. She sidesteps taxes on her entire wages because they are sheltered by a standard deduction of $4,750. True, earnings above $4,750 will cause Nadine to become liable for taxes; typically, though, the excess falls into the bottom income-tax bracket of 10%, which applies to taxable income of up to $7,000 (increased from $6,000 by the 2003 tax act).

Assuming you’re in a 35% federal and state bracket, hiring her lowers your taxes by $1,662.50 (35% of $4,750). However, just how much you actually save depends on whether Nadine’s wages are subject to Social Security and other payroll taxes.

Generally, the wages you pay Nadine and other employees are subject to Social Security (6.20%) and Medicare taxes (1.45%) that aggregate 15.30% (7.65% for both employer and employee). But Internal Revenue Code Section 3121(b)(3)(A) authorizes an exemption from these taxes for wages you pay to your under-age-18 sons or daughters. The exemption applies when you do business as: (1) a sole proprietorship (IRS lingo for the lone owner of a full-time or part-time business that is not formed as a corporation or a partnership with a partner other than your spouse) or (2) a husband-and-wife partnership. Consequently, whatever income you are able to shift to your children lowers your Social Security taxes by as much as 15.3%. The 15.30 rate applies just to the first $87,000 of 2003 net self-employment earnings (receipts minus expenses); beyond that, the rate drops to 2.90%.

Another break for Nadine is that each year she is able to put part of her wages into a Roth IRA–as much as $3,000 for 2003. The source of that $3,000 need not be her wages. It can be a gift from, say, you or her grandparents. True, she gets no deductions for her Roth contributions, but the write-offs would be worth little or nothing anyway because her brackets are low or zero. The big benefit is that those Roth contributions will grow without being taxed. Nadine can withdraw contributions at any time if she needs to tap the account. As for the earnings, there are restrictions. Generally, earnings can be withdrawn free of taxes only after she attains age 59 1/2, by which time they will have swelled enormously.

Regardless of how much Nadine receives as income from you or from other sources, you still can claim an exemption for her if you meet the following requirements. For the year in question, (1) you furnish more than half of her total support (count food, shelter, clothing, medical care, education, recreation, and similar necessities as support), and (2) she is either (a) under age 19 at year’s end, or (b) under age 24 at year’s end and a full-time student who spends at least five months in school (they do not have to be consecutive or full months). The exemption amount is $3,050 for 2003. And claiming an exemption for a child under the age of 17 qualifies you for the child tax credit, provided you satisfy its eligibility requirements. For 2003, the credit is $1,000, increased from $600 by the 2003 tax act.

Withstanding Audits

IRS auditors are understandably suspicious of deductions for wages paid to your own children. For the write-offs to survive scrutiny, you must be able to establish that the children actually render services. Expect the feds to throw out a deduction for hiring, say, a six-year-old to do photocopies; someone that age likely lacks the skills or discipline for office work.

Another hurdle is the “reasonableness” requirement. Wages paid to children cannot be more than the going rate for unrelated employees who perform comparable tasks.

That does not mean you have to be a stingy paymaster who doles out only the minimum wage. But it does mean that you have to treat your children the same as any other employee and keep the usual records showing amounts paid (a W-2, for example) and hours worked. Otherwise, the IRS might contend that the payments exceeded the going rate or that your youngsters were not bona fide employees (that they merely rendered the token kinds of services that parents expect their children to perform).

Tip: Responsible students are able to handle all kinds of chores. Some of the more common ones include answering telephone calls, cleaning offices, addressing envelopes, filing, bookkeeping, secretarial and other clerical work, and making deliveries. Nowadays, lots of kids are more adept with computers than older employees.

What Will Trip You Up

More than one parent has found out the hard way that it pays to play it straight.

In one case, the Tax Court threw out deductions for payments over a two-year period by an Indiana surveyor to his children, ages 9 and 11, for sweeping out his office and helping him with surveys. For one thing, he kept no records of the time they worked. And his case really went down the drain when the judge examined the children’s paychecks and found all of them had been redeposited in the father’s account.

In another case, the Tax Court concluded that the “salary” at issue–which had been turned over by Dr. Anthony R. Furmanski (an Encino, California, neurologist) to his teenage daughter–was merely an allowance, and not, as he claimed, wages paid for secretarial services at his office, and for regularly answering calls from patients at his home when the answering service was off and he didn’t want to be disturbed. Among other things, a skeptical judge noted that children normally answer the family phone. Nor was the doctor’s case helped by his admission that he made the entire payment to his daughter in advance–and paid nothing to his son for answering calls. The clincher was his failure to keep any records showing when she worked for him at the office or at home, or to withhold taxes on the payment.

What’s the key to winning these kinds of disputes? Be able to document that the children actually perform the chores for which they are paid, that the work is necessary for the business, and that the payments are reasonable.

Julian Block is a syndicated columnist, attorney, and former IRS investigator whose work has been covered by The New York Times and The Wall Street Journal. His “Year Round Tax Savings,” which explains the steps you should take to reduce taxes for this year and even gain a headstart for future years, costs $9.95 via e-mail or $14.95 (in the U.S.) via snail mail from julianblock@yahoo.com or J. Block, 3 Washington Square, #1-G, Larchmont, NY 10538-2032.