In today’s tough job market, students seeking summer employment, young adults looking for full-time employment, and college graduates looking to begin their careers are finding it difficult to land a job. The family business may be the only place for some family members to find work, even if only temporarily until another opportunity arises. Financially, it makes more sense to keep the family employed rather than hiring strangers, provided of course, the family member is suitable for the job, and not all are.
So rather than helping to support them with your after-tax dollars, you can instead hire them in your business and pay them with tax-deductible dollars. Of course the employment must be legitimate and the pay commensurate with the hours and the job worked. The following are typical situations encountered when hiring family members.
Employing a Child – A reasonable salary paid to a child reduces the self-employment income and tax of the parents (business owners) by shifting income to the child.
When a child under the age of 19 or a student under the age of 24 is claimed as a dependent of the parents, the child is generally subject to the kiddie tax rules if their investment income is upwards of $1,900. Under these rules, the child’s investment income is taxed at the same rate as the parent’s top marginal rate using a lower $950 standard deduction. However, earned income (income from working) is taxed at the child’s marginal rate, and the earned income is reduced by the lesser of the earned income plus $300 or the regular standard deduction for the year, which is $5,700 for 2010. Assuming that a child has no other income, the child could be paid $5,700 and incur no income tax. If paid more, the next $8,375 earned by the child is taxed at 10%.
Example: You are in the 25% tax bracket and own an unincorporated business. You hire your child (who has no investment income) and pay the child $10,700 for the year. You reduce your income by $10,700, which saves you $2,675 of income tax (25% of $10,700), and your child has a taxable income of $5,000 ($10,700 less the $5,700 standard deduction) on which the tax is $500 (10% of $5,000).
If the business is unincorporated and the wages are paid to a child under age 18, he or she will not be subject to FICA – Social Security and Hospital Insurance (aka Medicare or HI) – taxes since employment for FICA tax purposes doesn’t include services performed by a child under the age of 18 while employed by a parent. Thus, the child will not be required to pay the employee’s share of the FICA taxes and the business won’t have to pay its half either. In addition, by paying the child, and thus reducing the business’s net income, the parent’s self-employment tax payable on net self-employment income is also reduced.
Use the same example from above. Assuming your business profits are $130,000, and by paying your child the $10,700, you not only reduce your self-employment income for income tax purposes, you also reduce your self-employment tax (HI portion) by $287 (2.9% of $10,700 times the SE factor of 92.35%). But if your net profits for the year were less than the maximum SE income ($106,800 for 2010) that is subject to Social Security tax, then the savings would include the 12.4% Social Security portion in addition to the 2.9% HI portion.
A similar but more liberal exemption applies for FUTA, which exempts from federal unemployment tax the earnings paid to a child under age 21 while employed by his or her parent. The FICA and FUTA exemptions also apply if a child is employed by a partnership consisting solely of his parents. However, the exemptions do not apply to businesses that are incorporated or a partnership that includes non-parent partners. However, there’s no extra cost to your business if you’re paying a child for work that you would pay someone else to do anyway.
Retirement Plan Savings – Additional savings are possible if the child is paid more (or works part-time past the summer) and deposits the extra earnings into a traditional IRA. For 2010, the child can make a tax-deductible contribution of up to $5,000 to his or her own IRA. The business also may be able to provide the child with retirement plan benefits, depending on the type of plan it uses and its terms, the child’s age, and the number of hours worked. By combining the standard deduction ($5,700) and the maximum deductible IRA contribution ($5,000) for 2010, a child could earn $10,700 of wages and pay no income tax.
However, referring back to our original example, the tax to be saved by making a traditional IRA contribution is only $500 and it might be appropriate to make a Roth IRA contribution instead, especially since the child has so many years before retirement and the future tax-free retirement benefits will far outweigh the current $500 savings.
Hiring Your Spouse – Reasonable wages paid to a spouse entitles the employer-spouse to a business deduction. The wages are subject to FICA taxes, and the spouse may qualify for Social Security benefits to which he or she might not otherwise be entitled. In addition, the spouse may also be eligible to receive coverage under the business’ qualified retirement plan, and the employer-spouse may obtain a business deduction for health insurance premium payments made on behalf of the employed spouse. While maintaining the same family coverage, the business deductions could be increased by providing the spouse with family health insurance coverage as an employee.
If the spouse was unemployed (worked less than 40 hours) during the prior 60-day period, the employer will qualify for exemption from the employer’s 6.2% share of the Social Security payroll tax on the spouse’s wages for the remainder of 2010. If the spouse continues to work for an uninterrupted period of 52 weeks, the business would also be entitled to a retention credit of up to $1,000 in 2011. (Unemployed relatives such as children, siblings or parents whom you may hire are not qualified employees for this credit.)
If you have questions about the information provided here and other possible tax benefits or issues related to hiring your spouse or child, please give this office a call.
Steve Trojan, CPA is owner of SMT & Associates, Inc. (www.smt-associates.com), a Crystal Lake IL based tax and accounting firm, and Complete Payroll Inc, (www.completepayrollinc.com) a payroll processing firm. He specializes in tax and accounting issues affecting small business owners.