Deciding whether to hire family members in your small business should take into consideration a range of variables, including business objectives, family dynamics, individual goals and fairness, to name a few. That said, it’s worthwhile to take a brief look at how the tax code might treat these working relationships, and explore any incentives that might exist from a tax standpoint.
If you decide to put a family member on your payroll, please keep in mind that the IRS expects this to be a true employer-employee relationship. That is, the family member, whether a child or spouse, is to have real duties and involvement in the business, and the pay for those services is expected to be reasonable and commensurate with the value of the work performed. Hence, it is not expected to be a paper transaction only.
Since every business is unique and situations vary, often you’ll need to run the numbers before determining whether any actual tax benefits will ensue. One of the underlying themes in this sort of analysis is that the tax burden is often evaluated with respect to the overall family tax burden, and not strictly an evaluation of each component of the business and family separately. For example, paying a wage to your minor child may cause the child to pay some tax, but in return the business/owner stands to save a greater amount on its own tax bill. This typically would result from the difference in the marginal tax rates of the owner (presumably higher) and child (lower).
Potential tax breaks take various forms under the federal tax code. For example, some family members are exempt from certain payroll taxes. Children under age 18 working in a business owner’ s sole proprietorship are exempt from Social Security taxes, while children under 21 and spouses working in the same business are exempt from federal unemployment taxes. As such, wages paid to a 17-year-old child could produce net savings of both income and Social Security taxes for the business owner and family overall. Since the child is now a wage earner, this opens up the possibility for the child to establish an IRA account, whether Roth or traditional, in their own name. Such an account can help develop the child’s financial literacy, develop long-term savings habits, or even pay for qualified college expenses, which can be exempt from early withdrawal penalties later on. Finally, on the topic of payroll, generally speaking, sole proprietorships, including single-member LLCs, tend to offer the widest array of intra-family payroll tax savings relative to corporations and most partnerships, although again, situations vary.
While the payroll-tax savings opportunities in a sole-proprietorship are more limited with a spouse as compared to a child, there is an opportunity for tax savings in connection with health insurance premiums for spouses. Briefly, sole-proprietors are allowed an above-the-line income tax deduction for premiums they pay for themselves, their spouses and dependents, on their annual Form 1040. When structured properly, this deduction can be converted into a direct business deduction, which goes to reduce both the income taxes and Social Security taxes generated by the business. To achieve this, there must be a true employer-employee relationship between the business and the spouse, and the health insurance plan for which premiums are paid must be purchased in the name of the employee-spouse. From there, the insurance plan can be structured to cover the spouse’s family, which of course now includes the employer/business owner. As a business fringe benefit, the value of the plan is not taxed to the spouse, but is fully deductible to the business. Of course, you’ll want to be sure you’ve covered all the bases with such a plan, so be sure to seek advice as needed.
With respect to C-corporations and the proverbial double-taxation problem, employment of family members can offer tax-favored ways of achieving deductions at the corporate level and extracting cash from the business in a tax-efficient manner.
The above discussion has touched on three basic methods of tax savings through employment of family members: income shifting, payroll taxes and fringe benefits. The ability to use any one of these methods will be impacted by such variables as type of tax entity, e.g. sole proprietor vs. corporation, relevant income levels and the specific family relationship involved, to name a few. In order to use any of these techniques, there needs to be a bona fide employer-employee relationship in existence. Deciding whether to hire a family member to work in the business involves both tax and non-tax factors. As intricate as some of these tax positions might seem, any decision involving family members in the business is multi-faceted, crisscrossing the lines of business thinking and family dynamics, and goes beyond strictly the tax-related issues.
Arthur Caccamo is a manager based out of our Albany, NY office.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.