April 6, 2022 – Many of our small business clients ask us, “Is it true that hiring family members can bring significant tax benefits to our business?”
In short, yes! The Tax Code is “generous” in supporting small businesses and families. Combine the two with a willingness to follow the tax rules, and let Uncle Sam help your financial picture – from medical insurance to tax-free college tuition.
First, the Rules:
There are not many special rules to keep in mind when hiring a family member. In most cases, it is best to treat a family member like any other employee. For example, you must:
- Ask for a W-4 from each family member and keep federal and state income taxes based on your chosen systems.
- Keep the appropriate amount of FICA taxes from the payment of each family member. In other words, you still (generally) have to deduct Social Security and Medicare taxes from your family wages. We’ll talk about exceptions later.
- When calculating unemployment tax (FUTA), withhold the employee share and have the company pay the employer portion for the family members.
- If your family members work overtime for you, you must pay them the same rate as other employees (1.5 times after 40 hours of work).
- Be Mindful the Federal Child Labor Act provides strict guidelines on when and how long children can work and what type of work they are allowed to complete.
The most important rules to follow are:
- Do not pay family members who do not work.
- Do not pay family members a wage that is more than the market rate for their work.
- Follow practices as you would for an employee who is not a family member and keep “squeaky clean” records.
Now the Benefits:
So, you may want to hire your child(ren) to work in your business. And you want to do it for many good reasons: to teach them about entrepreneurship, develop a strong work ethic, AND for the tax-free income — up to $12,950 per child (the standard deduction in 2022).
You can hire your kids and pay them up to $12,950 per year tax-free. If you hire your son to stuff envelopes and your daughter to update your website, you can lower your income by $25,900 simply by engaging your children in the family business!
If they stay under this limit, they don’t even have to file a tax return, which means they don’t pay any income tax. And you get to deduct the wages paid, which lowers your business’s taxable income and reduces your tax liability!
Super-Charge the Benefits:
Hiring your children is a strategy that can also be combined with IRA and 401k strategies to really maximize the benefit.
For instance, if you paid each child $12,950 as salary, you could put $6,000 into an IRA deductible by the child. Using the standard deduction to take their taxable income to zero allows your business to deduct $18,950 per child, again, with no taxable income!
You can tweak the strategy and put the $6,000 contribution into a Roth IRA. While there will not be any current deduction for the child, it can be withdrawn and used to pay for college. Assume your child works for you for ten years before attending college and contributes $6,000 per year to a Roth account. When ready for college, the balance in the Roth account, assuming a 5% growth rate, will approximate $63,000. These funds represent college savings funded on a pre-tax basis! One caveat is that withdrawals from a Roth account could impact the Financial Aid calculations. If you believe you will be eligible for need-based financial aid, consider funding a deductible IRA for their retirement and funding college with after-tax funds via a 529 account.
What Could Count as Work?
There are countless jobs kids can do for you. Remember, you can pay them at the SAME RATE you would pay any other employee or outsourced company (I recommend 5% lower for the optics).
- Cleaning the office
- Washing company cars
- Mowing the lawn/gardening around the office property
- Updating customer lists on the computer
- Simple to advanced Data-entry
- Transcribing video or audio
- Trips to the post office or general errands
- Helping at the office, passing out handouts, and more
- Walking door-to-door, placing fliers for your business
- Updating your social media accounts (They won’t even equate this as work!)
Technically, you can hire a child at any age; however, IRS case law has documented employing children as young as seven.
Don’t Try This Alone!
Additional strategies, including those relating to employee benefits for a spouse/family member, could minimize your tax liability. Consider:
- Medical Reimbursement Plans – Sec. 105(b)
- Qualified Small Employer Health Reimbursement Arrangements
- Converting Entities in a Community Property State to Minimize Self-Employment Tax
- Creating a Family Management Company to Utilize Family Benefits in a Corporate Structure
Bottom Line
I have previously written about our patriotic right not to pay more taxes than are legally required – Read “More Than Your Fair Share.” The strategies outlined here are sanctioned by the IRS if you know and follow the rules.
The IRS isn’t going to believe your 6-year-old earned $12,950 analyzing medical records. But that 6-year-old can model those pearly whites in photographs to be used on your website or brochure if an easy-to-document “image agreement” pays an ongoing licensing fee right from the start.
Please pass along this information to any “entrepreneurial” family of friends who might be interested and call the office if you would like to learn more about hiring family members.