If one or both parents have a business, then there can be significant tax savings if it is organized as a family business, which includes other members of the family as shareholders or as limited partners. The family business would have to be organized as a partnership, limited liability company, or as an S or C corporation. However, a family can form a number of different business entities to maximize tax savings, although this would have to be weighed against their cost of the operation and the administration of the entities. Family members can also help to start a business by pooling their resources. Furthermore, a family business can also be an effective estate planning tool. However, a family business must be a real business — it cannot simply be a means to transfer wealth to descendents. This generally means that it must be an active business, so a family business that holds only investments, would not qualify.
There are several major tax advantages to a family business. Families can hire their minor children and pay deductible wages. Neither the business nor the minor children have to pay either Social Security and Medicare (FICA) taxes or federal (FUTA) and state unemployment taxes if the child is under 18. [IRC §3121(B)(3)] The child would not have to pay any taxes for wages up to the standard deduction for the child. However, the rate of pay would have to be in the neighborhood of what a business would pay a stranger, although the compensation could be somewhat higher since compensation does vary considerably for the same job. A traditional IRA can also be set up for the child, allowing an additional $5,000 of income that can be tax-deferred, although a Roth IRA would be more advantageous for a minor, since the tax savings would be insignificant.
So if a parent in the 25% tax bracket pays his child $10,000 in wages to work for his business, then the $10,000 can be deducted from the business income, saving $2,500 in ordinary income taxes plus about $1,400 in self-employment taxes that the parent would have to pay if it were part of his income.
Children can also be given stock in the family business. They do not have to work in the business nor do they have to pay for the stock themselves. However, if the children do not work in the business, then their income will be subject to the kiddie tax.
Families can also put their older parents on the payroll if they are retired, but it only makes sense if the parents are in a lower tax bracket, need the income, and if it does increase taxes on their social security benefits.
Since 2007, the IRS has allowed a form of business entity where spouses can work as co-proprietors — each must participate in the business and file a Schedule C reporting their share of their income, and there can be no employees, including their children. Both spouses will also have to pay self-employment tax. But a co-proprietorship is easier to manage and to administer than a partnership.
Sometimes, it is advantageous to have a spouse volunteer to work in a business, working without pay, which can save a considerable amount of taxes if the owner spouse has an income greater than the Social Security contribution and benefit base, which for 2012 is $110,100. For instance, suppose the working spouse earns $200,000 a year from her business and she decides to pay her spouse $50,000 per year to work in the business. In such a case, the family unit would have to pay 15.3% in employment taxes on the income to the other spouse, but if the spouse simply volunteered to work in the business, then the $50,000 would only to be subject to the 2.9% Medicare tax of the high-income spouse. (Actually, the percentage would be a little less than this, since a self-employed person only has to pay self-employment tax on 92.35% of her income, yielding an effective tax rate of 0.029 x .9235 = 0.0268 = 2.68%. Tax law also permits a deduction of the amount of the self-employment tax owed, lowering the percentage even further, but the actual percentage will vary depending on the taxpayer's tax bracket. See Self-Employment Tax for more details.)
Family Limited Partnerships
A family business can be organized as a partnership, limited liability company, an S corporation, or as a C corporation. Although a C corporation has the largest tax benefits, any dividend income will be subject to double taxation. Moreover, S and C corporations are more complicated business entities and additional taxes, such as the state corporate franchise tax, would also have to be paid. A limited liability company with 2 or more members is taxed as a partnership, and while general partnerships are easy to organize, they can have complex tax consequences.
For income tax purposes, a family member can only be a partner if she owns a capital interest in the partnership in which capital is a material income producing factor; otherwise, the IRS may disregard the partnership as an assignment of income to the family member. If the parents do all the work, then they will be taxed on the entire income. The distributive share of income must be proportional to the capital interest of the partner and the partner must have proportional voting rights in the partnership. IRC §704(e)
One of the most common ways of organizing a family business is as a family limited partnership (FLP), which is taxed like a limited partnership but in which the children do not have to contribute capital or even work in the business. The spouses act as general partners and the children are limited partners. As limited partners, the children have no say in the business. The benefit of the limited partnership is that the parents can transfer shares of the partnership to the children tax-free if the value of the shares is less than the annual gift tax exclusion limit, which is $13,000 for 2012. A married couple can double that amount for each child.
Additional tax savings can be achieved because shares in a family corporation or a family limited partnership or limited liability company can usually be discounted by at least 15 to 20%, and sometimes by as much as 50%, especially for shares that have no voting rights or have other trading restrictions. Larger discounts can be justified if the spouses maintain most of the control of the business, which is usually the case. A higher discount would also be plausible if the shares pay no dividends or are never redeemed, since redemption would set the price of the shares. Other factors that may affect the discount of the shares is whether the stock is publicly traded or not, the competitiveness of the business, and the competence of the company management. However, the IRS will may require a professional assessment of the value of the shares to ensure that their value is less than the gift tax annual exclusion amount.
Employee Stock Ownership Plans
Employee stock ownership plans (ESOPs, IRC §404) are another effective way to transfer income to children but they can only be offered by a C corporation, and the children would have to be employees of the corporation. However, it must be offered to all full-time employees, not just family members, so this would only yield significant tax savings for a closely held corporation. The corporation can make annual contributions of the stock to an ESOP trust — the corporation can deduct the contribution and it is not treated as income to the employees. The corporation can contribute up to 25% of the total of employee salaries, and each individual employee is given a number of shares that is proportional to the percentage of their salary over the total compensation paid by the corporation.
Example: If the total value of a corporation's stock is $1 million and it pays out $500,000 in salaries to employees, then it can contribute $500,000 x .25 = $125,000 to purchase corporate stock for the ESOP, which represents 25% of the total payroll of the company and 12.5% of the company stock. So an employee who makes $80,000 can be allocated 2% of the stock annually ($80,000 / $500,000 x 12.5% = 2%).
However, there are expenses, since a CPA or tax attorney would have to be hired to set up the ESOP because of its complexity, but at least the cost would be deductible.
Few people will be subject to the estate tax, since the exemption amount is so high. For instance, in 2011 and 2012, the exemption amount is $5 million per individual, so a married couple can leave $10 million tax-free to their descendents. There are many tax loopholes to save even more on estate taxes, thanks to a tax code that favors the wealthy — a family business is one of those ways. However, if most of the business interest in the family business becomes part of the parents' estates, then the heirs still have several options. One possibility is to pay the estate taxes with the proceeds of a life insurance policy. Note, however, that joint ownership does not save on estate taxes unless the joint owner is a surviving spouse.
Another option is to pay the taxes in installments. When the business owner dies, there is no need to liquidate a family business to pay estate taxes, since the IRS has an installment payment option to allow a cash-poor estate to pay estate taxes over a longer time period. A closely held business that composes 35% of the adjusted gross estate can pay the estate tax in 10 annual installments after a deferral period of as much as 5 years. However, only the tax attributable to the business interest is deferrable. Furthermore, for 2012, the 1st $1,390,000, adjusted annually for inflation, is charged only a 2% interest rate. Some business stock can be redeemed to pay estate or generation-skipping transfer taxes without disqualifying the estate or the beneficiaries from taking advantage of the installment payment option.
Qualified Family-Owned Business Interest
Starting in 2013, the exemption amount for estates is scheduled to return to $1 million, but up to $675,000 of a qualified family-owned business interest (QFOBI, IRC §2057) can be deducted from the estate that includes a family owned business, which is a business where at least 50% is owned by 1 family, 75% by 2 families or 90% is owned by 3 families. If more than one family owns the business, then the decedent's family must own at least 30%.
The decedent's interest can only qualify as a QFOBI if the decedent or member of the decedent's family owned and materially participated in the business for at least 5 of the 8 years before the decedent's death. The decedent must have been either a United States citizen or resident at the time of death. Furthermore, the heir or a member of his family must materially participate in the business for at least 5 years within any 8 year period within 10 years after the decedent's death. Material participation generally means either physically working or managing the business. If the heir fails to satisfy these requirements, then the amount deducted is subject to recapture in the year of disqualification, in which case, the heir must file Form 706-D, United States Additional Estate Tax Return under Code Section 2057.
IRS Publication 501, Tax Rules for Children and Dependents