Employing Family Members in Your Business: Tax Strategies and Tips

October 17 , 2023

Employing family members into your business can be a thoughtful and strategic decision. Whether you operate a small enterprise or a larger firm, there are undeniable advantages, including unique skills and the opportunity to foster responsibility and entrepreneurial spirit. However, what often goes unnoticed are the significant tax benefits that may come with this choice. In this article, we’ll explore these potential advantages and provide insights into effectively managing family members as employees and independent contractors. Join us as we delve into the financial potential of family collaboration in your business.

Benefits of Employing Family Members

The choice to employ family members is driven by a variety of factors that not only benefit the business but also offer substantial tax advantages. Here are some key advantages to consider:

1. Unique Skills and Qualifications

Family members often bring unique skills and qualifications to the table, and they may indeed be the best fit for certain roles within the company. This can lead to increased efficiency and productivity.

2. Fostering Responsibility and Entrepreneurial Spirit

Involving family members in the business provides an opportunity to instill a sense of responsibility and an entrepreneurial spirit in younger family members. This not only contributes to their personal growth but also enhances the business’s overall success.

3. Tax Benefits for Your Business

Employing family members can strategically position your company for significant tax savings come tax season, making a notable impact on your financial bottom line. Some key tax advantages include:

• Reduced Taxable Income: Allocating a portion of your business income as wages to family members can reduce your taxable income, potentially placing you in a lower tax bracket and lowering your overall tax liability.
• Income Splitting: Distributing income among family members can help distribute the tax burden more evenly, potentially resulting in significant tax savings.
• Deductions for Employee Benefits: Offering benefits to family employees, such as health insurance or retirement plans, can result in tax deductions for your business, further reducing your tax liability.

Understanding and strategically utilizing these tax advantages can lead to substantial savings for your business.

Employing Family Members

When managing family members as employees within your business, it’s vital to understand that not all familial ties are treated equally in the eyes of tax and employment laws. Here, we’ll explore some essential distinctions based on the nature of these familial relationships and the ages of the individuals involved.

1. Hiring a Spouse

When employing your spouse, their wages are subject to income tax withholding, Social Security, and Medicare taxes. If your business is a corporation or partnership (even if your spouse is a partner), FUTA tax is also applicable.

2. Hiring a Parent

When parents are employed by their child, the tax treatment varies depending on the type of business.

For a sole proprietorship the following applies:

• Income Tax
• Social Security and Medicare Taxes
• No FUTA tax is applied.

For a corporation, partnership, or an estate the following applies:

• Income Tax
• Social Security and Medicare Taxes
• FUTA Tax

3. Hiring Children

When you hire your child, the tax treatment of their wages depends on their age and the structure of your business.

For Sole Proprietorships and Partnerships (Where All Partners Are Parents of the Child):

• Income Tax: Payments for a child’s work are subject to income tax withholding, no matter how old the child is.
• Social Security and Medicare Taxes: If the child is under 18, you don’t need to pay social security and Medicare taxes on their earnings. But if they’re 18 or older, you must pay these taxes.
• Federal Unemployment Act (FUTA) Tax: If the child is under 21, you’re exempt from paying Federal Unemployment Act (FUTA) tax. However, if they’re 21 or older, this tax applies.

For Corporations, Partnerships (Where Not All Partners Are Parents of the Child), or Estates:

• Income Tax: Withholding income tax on payments for services provided by a child is required, regardless of the child’s age.
• Social Security, Medicare, and FUTA Taxes: The responsibility to pay social security taxes, Medicare taxes, and FUTA taxes on a child’s earnings applies to children of all ages.

Key Considerations When Employing Your Child

Hiring your minor children can offer significant tax advantages for parents in the realm of tax planning. The ‘kiddie tax,’ for example, doesn’t apply when a business operator employs their child because earned income is not subject to this particular tax.

Moreover, children earning less than the standard deduction, which in 2023 is $13,850 per child, typically won’t have federal income tax liabilities. Additionally, parents can still claim these children as dependents, providing further tax benefits.

An often-overlooked advantage of employing a minor child is the opportunity to kickstart their savings. Money earned through such employment qualifies as earned income, making it eligible for contribution to an individual retirement account (IRA). This early savings can lead to significant financial growth, with a Roth IRA being a popular choice.

Before proceeding with hiring their children, we advise our clients to ensure that the work is both legitimate and suitable for their child’s age. It’s essential to avoid any appearance of ‘ghost payroll’ schemes. Hiring a relative should always involve real and meaningful work contributions.

Furthermore, business owners should carefully consider their child’s age when assigning tasks. While labor law exceptions exist for family members, it’s crucial to prioritize safety and age-appropriate responsibilities. Examples of suitable tasks may include cleaning, filing, inventory, or photocopying.

Lastly, it’s essential to ensure that the compensation for the child’s work is fair and aligns with industry standards. Payment should always reflect the nature and scope of the work performed.

Onboarding Family Members

When you choose to bring family members into your workforce, it’s crucial to ensure a smooth and professional onboarding experience. While there may be some steps you can skip due to your existing familiarity with them, treating them like any other employee remains essential. Here’s a structured approach to navigate this process effectively:

• Initial Documentation: When you decide to hire family members, it’s important to initiate the onboarding process just as you would with any other employee. Begin by collecting necessary paperwork from your family members, which typically includes forms like the W-4, state-specific W-4 (if applicable), and Form I-9.
• Payroll Inclusion: Make sure to include your family members in your payroll system. If you plan to offer direct deposit, gather their bank account details to ensure prompt payment.
• Tax Compliance: Maintain tax compliance by correctly withholding the necessary taxes from your family members’ gross pay. If your regular practice involves timesheets or time and attendance software, ensure you collect and keep accurate time records before proceeding with payroll processing.
• Detailed Pay Stubs: Every family member employee benefits from clarity in their compensation. Provide each of them with comprehensive pay stubs that break down key details, including gross pay, taxes withheld, deductions, and net pay. This practice promotes transparency and professionalism in your working relationship.

Hiring Family Members as Independent Contractors

Hiring family members as independent contractors is a strategy that can be beneficial for your business’s bottom line. It’s a route that can help you avoid payroll taxes, but it comes with certain conditions that must be met to classify your family members as contractors rather than employees. Here, we’ll delve into the essential considerations and guidelines you should keep in mind.

Generally, independent contractors are individuals whom a business contracts for specific projects or time periods. Conversely, employees typically have a more permanent and structured role within the organization.

The Internal Revenue Service (IRS) scrutinizes three key categories of control when determining whether a worker should be classified as an employee or an independent contractor:

• Behavioral Control: If your business dictates when, where, and how a person works and provides detailed instructions or training, the individual is likely considered an employee. Independent contractors, on the other hand, have more autonomy in deciding their work methods and schedules.
• Financial Control: If your business exerts control over the financial aspects of a worker’s job, such as providing equipment or paying a regular wage or salary, the worker is generally classified as an employee. Independent contractors typically purchase their own equipment, set their rates, and send invoices based on project fees.
• Nature of the Relationship: The nature of the work and the relationship between your business and the worker also play a crucial role. If the worker is performing services that are central to your business’s operations, lacks a formal agreement specifying independent contractor status, and has limited control over their work, they are more likely to be considered an employee. Additionally, offering employee benefits like health insurance, paid vacation, and sick days, or hiring a worker with the expectation of an ongoing, indefinite relationship, leans toward an employee classification.

While hiring family members as independent contractors can offer advantages in terms of tax savings and flexibility, it’s essential to tread carefully. Ensure that your working relationship with them aligns with the criteria established by the IRS to avoid legal issues and potential fines.

Key Points

In conclusion, integrating family members into your business can be a rewarding and strategic decision, offering a blend of skill sets, values, and the potential for significant tax savings. Whether you’re hiring a spouse, parent, or child, understanding the tax implications and maintaining professionalism in the onboarding process is key. Remember, a family business can thrive when built on a strong foundation of trust, responsibility, and shared goals.

Seeking personalized guidance on family employment and taxation? We invite you to consult with your dedicated tax advisor for expert support in making informed decisions that will ensure your venture’s success and long-term financial well-being.