Many self-employed people want to hire family members to work
for them. But as with many things in life, there's a right way
and a wrong way to do this. Doing it correctly not only promotes
family togetherness, it can also create tax savings for you.
When you hire a family member your business can take a deduction
for reasonable compensation paid to this employee, which
consequently reduces the amount of taxable business income that
flows through to you. I emphasize reasonable compensation because
the IRS can question compensation paid to a family member if the
amount doesn't seem reasonable given the services actually
performed. Also, you must be sure your business complies with child
labor laws when hiring a family member who's a minor.
There are other benefits to hiring a family member. As a
business owner, you're responsible for paying Federal Income
Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA)
taxes on wages paid to your employees. FICA is the law requiring
employers and employees to pay Social Security and Medicare taxes.
FUTA is the law that establishes federal unemployment taxes.
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As with wages paid to all employees, wages paid to family
members are subject to withholding of certain taxes in some states.
Typically, the payment of these taxes will be a deductible business
expense for tax purposes. But if you hire family member--a child,
spouse or parent as an employee--to work for your business you may
not have to pay FICA and FUTA taxes.
For instance, you don't have to pay FUTA taxes for services
performed by a child under 21 years old. And you don't have to
pay FICA taxes for a child under 18 and works in your trade or
business or a partnership owned solely by you and your spouse. For
family members under age 18, you don't have to withhold for
FICA, Medicare, FUTA and SUTA. If your spouse is employed, you
don't have to withhold for FUTA and SUTA, but must withhold for
FICA and Medicare.
For example, Cody, age 15, proofreads press releases for his
mother's public relations business, which is operated as a sole
proprietorship. Cody is his mother's employee, but she
doesn't have to pay FICA taxes until Cody turns 18, and FUTA
taxes until he turns 21.
Note that these rules don't apply if you hire your child to
work for your corporation or your partnership, unless all the
partners are parents of the child. For example, Callie works in a
landscaping business that's half-owned by her father and
half-owned by her father's brother. FICA and FUTA taxes will
have to be paid because it's a partnership and not all the
partners are Callie's parents.
Additionally, if your child has no unearned (dividend or
interest) income, then you must withhold income taxes from your
child's pay only if it exceeds the standard deduction for the
year. For 2005, the standard deduction is $5,000; this figure is
adjusted every year for inflation. Children who are paid less than
this amount don't have to pay any income taxes on their
earnings. If your child has more than $250 in unearned income for
the year and his or her total income exceeds $750, then you must
withhold income taxes.
If you pay your child more than $600 or more during the year,
you must file a Form W-2 reporting the earnings to the IRS.
Regardless of how much you pay your child, each year you should
fill out and have your child sign IRS Form W-4, Employee's
Withholding Allowance Certificate. If you pay your child more than
$200 per week, keep a copy of the form for your records and file a
copy of the form with the IRS.
For small-business owners who are concerned about succession
planning, hiring children can provide non-tax benefits as well.
Children who play a role in a business can help it survive past the
owner's involvement.
Meanwhile, if you employ your spouse to work in your trade or
business, the payments are subject to FICA taxes and federal income
tax withholding, but not FUTA taxes. This rule doesn't apply if
your spouse works for a corporation--even if you control it--or a
partnership--even if your spouse is a partner along with you. In
that case, you will have to pay FUTA taxes.
Finally, if you employ a parent in your trade or profession, his
or her wages are subject to income tax withholding and the FICA
taxes, but not FUTA taxes.