Tax advantage: Hiring family members – pros and cons?
Hi, it’s your Money Mavens. Quick question…
Where is the best place to find good employees and contractors who can be great tax advantages for your business?
If you answered with Upwork, Monster, or Indeed, those are good answers, but there may be a better place to look.
Your own family!
Hiring your family members can help in more ways than simply filling a key role in your business.
Depending on your business structure, it can help you as the business owner save for your retirement and lower your family’s overall tax liability.
“Oh, I would love to work with my mom! We get along so well!”
If that’s crossed your mind, that’s exciting to think about, right?!
Of course, as with anything important in life, it’s crucial to consider the pros and cons. Is it worth it for you to hire one of your family members to work inside your business?
On the tax side of the conversation, you want to know how your overall tax strategy, specifically your employment tax to payroll and employee classifications are structured.
You need to understand what tax rules may influence your hiring decision before making any hiring moves, family member or not.
Expensive tax mistakes are easily avoidable with good due diligence and insight guided by a tax professional..
If you do understand the tax implications, there are other key factors you need to consider when hiring a family member…
Any family member you hire needs to be an actual employee.
Yes, hiring family members can be a useful strategy for reducing your overall tax bill, but only if they are bonafide employees.
This means they contribute value to your business and perform duties that benefit your business. What’s their job description and how are they expected to show up as an employee?
Making them a legitimate employee allows you to deduct the compensation paid to them.
In other words, you are converting higher-taxed income into low- or zero-taxed income.
Your working relationship matters just as much to the IRS.
Your personal/familial relationship with your family member and your professional relationship to them as your employee are both of interest to Uncle Sam.
The IRS has different rules for employment taxes depending on if the family member is a spouse, a child, or a parent.
There are also IRS regulations that are applicable based on what type of business entity you use in your business structure.
A sole proprietorship can have vastly different regulations for hiring family members versus a partnership or corporation making the same hire.
As an example, according to the IRS when one spouse is employed by another, the earnings from the employed spouse are subject to income, Social Security, and Medicare taxes. They are not subject to Federal Unemployment Taxes (FUTA).
For a child hired by a parent, children under the age of 18 are not subject to Social Security and Medicare taxes as long as the business is a sole proprietorship or a partnership where each partner of the business is the parent of the child.
In this situation, wages are not subject to FUTA taxes if the child is under 21. Wages are subject to income taxes regardless of their age.
If the business is a corporation or a partnership in which only one parent is a partner, then the child’s wages are subject to income, Social Security, Medicare, and FUTA taxes.
For parents who are employed by their children, earnings are subject to income, Social Security, and Medicare taxes. However they’re not subject to FUTA taxes.
Retirement Benefits Can be Especially Advantageous
If your business satisfies the required tax code guidelines, you may be able to deduct your spouse’s entire retirement plan contribution from payroll.
Your spouse can benefit by deferring a portion of their salary and any possible catch-up contributions if they are over 50 years old.
Many couples that work together (and have no other employees) install a Solo 401(k) plan. This is a great way for you and your spouse to contribute to your retirement savings.
As the owner, you can contribute to your Solo 401(k) as both the owner and the employee.
The contribution limits are adjusted for inflation every year and in 2022 you can contribute a combined total of $61,000 (plus $6,500 if you’re 50 years old or older). And as long as your spouse does not have another 401(k) plan, they can also participate and contribute $61,000 (plus $6,500 if 50 or older) – assuming you’ve paid them at least that amount.
Helping Your Child Save for the Future
For a child, their earned wages can be used to open and fund Roth IRAs.
By paying taxes now on the earned income that they use to fund their Roth IRA, they can maximize the potential long-term growth of the money overtime and look forward to tax-free earnings by the time the child is over 59 ½ years old. In 2022, they can contribute up to $6,000 as long as you’ve paid them at least that amount.
So, What’s the Next Step?
Do you have someone in your family who is already working for you or someone that you have been thinking about asking to work with you?
The first step is likely consulting with your tax professional to talk about the tax and business entity implications of a family member working in your business.
You want to also ensure you have solid recordkeeping structures and basic business practices in place, such as an employee guidebook or manual.
This will help you, your entire team, your tax professional, and other key voices connected to your business have clarity about what you may expect.
The IRS will pay closer attention to your business and how it’s run, increasing your chances for a ‘random’ audit.
With good recordkeeping, time reports, a reliable payroll system, copies of payroll return records with transparency regarding compensation, and the right business structure in place, there should be no need to worry.
Part of doing your due diligence is knowing how your local laws can affect your business when it comes to hiring a family member.
For more information, check out these resources provided by the IRS:
But what if you have more questions? We work with our clients on matters like these and much more while helping them grow their business and their net worth. If you are interested in finding out more about our business owner services click here.
To your prosperity,
Your HWM Money Mavens
P.S. – Two of our team members are actually sisters! Can you guess who they are?