One of the advantages of owning and operating your own business is the ability to hire family members to fill open positions. This can be a significant perk in today’s tight labor market. Bringing on family members can have tax benefits for all involved, too, and offers an opportunity to start a retirement savings account for your children.
The potential benefits vary based on such factors as the familial relationship, your children’s ages and the type of entity you chose for your business. Here’s what you need to know.
Hiring Your Spouse
When your spouse goes to work for your business, his or her wages are subject to income tax withholding and Social Security and Medicare taxes (more commonly known as FICA taxes) but not Federal Unemployment Tax Act (FUTA) taxes. Employers generally must pay 6.0% of an employee’s first $7,000 in earnings as the FUTA tax, subject to tax credits for state unemployment taxes paid. That means you save the money you’d otherwise spend for a nonspouse employee’s FUTA.
It’s important that your spouse is compensated as an employee, though. When spouses carry on a business together and share in the profits and losses, the IRS may deem them partners (even in the absence of a formal partnership agreement).
You also may reap some savings from hiring your spouse if you’re a sole proprietor and have a medical reimbursement (or Section 105) plan. Your family can receive tax-free reimbursement from the business for medical expenses, and the business can deduct the reimbursement payments, reducing your income and self-employment taxes. The reimbursements aren’t subject to FICA taxes and are tax-free fringe benefits for your spouse. Note, though, that this strategy isn’t available if you have other employees.
Employing Other Family Members
Children who work for their parents’ businesses are subject to income tax withholding regardless of age. If the business is a corporation or partnership, children’s wages also are subject to FICA taxes and FUTA taxes, unless each partner is a parent of the child. But substantial savings are possible for a business that’s a sole proprietorship or a partnership in which each partner is a parent of the child-employee, depending on the child’s age.
Those children who are under age 18 aren’t subject to FICA or FUTA taxes. When FICA taxes apply, the employer and the employee each must pay 7.65% of the employee’s earnings (subject to annual limits). Avoiding FICA means more money in the pockets of both you and your child.
Children who are 18 to 20 years old aren’t subject to FUTA taxes. But they’re subject to FICA taxes.
It’s worth noting that children generally are taxed at lower rates than their parents. Moreover, a child’s income can be offset partially or completely by the child’s standard deduction. If your child earns less than the standard deduction amount, it’s tax-free for the child, on top of being deductible for the business.
In addition, your child’s earned income can be contributed to an IRA, with the potential for impressive compounding over time. As earned income, this money also isn’t subject to the so-called “kiddie tax.”
There are benefits to be had from hiring your children who are 21 or older, as well. A sole proprietor parent can provide up to $5,250 in annual educational assistance, tax-free to an employee who is:
- A legitimate employee of the business,
- Not more than a direct 5% owner of the business, and
- Not a dependent of the sole proprietor.
Parents can deduct the cost of the educational assistance, cutting their self-employment and income tax liability. Educational assistance payments also aren’t subject to FICA or FUTA taxes.
What about hiring your parents? The wages of parent-employees are subject to income tax withholding and FICA taxes. You don’t have to pay FUTA taxes, however.
For tax purposes, family members must be bona fide employees who perform age-appropriate work that needs to be done. They also must be paid a reasonable, non-excessive amount for the work performed. Of course, you also want your family members to be qualified for your own reasons. Tax breaks are rarely worth putting the wrong person in the wrong job.
Employing unqualified or overpaid family members also risks alienating any employees who aren’t family members. You can damage their morale if family are seen as receiving favorable treatment. Consider placing young family members on lower rungs of the “ladder” and teaching them the basics, rather than putting them in positions they’re not ready for yet.
You also should consider the implications for familial relationships, including those with relatives who aren’t hired. Working together can lead to stress, and resentment can fester in even the closest of families.
Do It Right
If you decide to hire family members, you need to dot your i’s and cross your t’s. For example, keep thorough records, including timesheets and formal job descriptions. Timely file the necessary payroll tax returns, conduct regular performance appraisals and check any applicable state laws. Above all, contact your tax and legal advisors to ensure you’ve covered all the bases.
For More Information
Contact your tax advisor to learn more.
This article was originally published on July 28, 2022 on Porte Brown’s NewsBlog.