Tax Advantages of Family Employment
Sole proprietors and husband-and-wife partnerships can save significant taxes by employing family members. However, for these tax rules to apply, family members must do bona fide work and be paid market wages for the skill level involved. It cannot be sham work nor can outrageous wages be paid for menial tasks, especially for children. A family business can also be used to reduce gift and estate taxes on gratuitous transfers. See Family Businesses for more information about family limited partnerships, stock ownership plans and estate planning.
Employing Children Younger Than 18
Dependent children younger than 18 offer the greatest tax-saving opportunity. There are no tax advantages to employing children who are at least 18. Sole proprietors and husband-and-wife partnerships can employ their children to save on taxes, since the children are not subject to employment taxes on their income, and if their income is below their standard deduction, then they do not have to pay income taxes either. Moreover, a business owner does not have to pay the employer's share of employment taxes or federal unemployment taxes for the child's wages.
If the child uses the money wisely, especially to buy things that the parent would otherwise have to pay for, this could offer significant savings for the family. Note that a child that provides more than ½ of his own support cannot be claimed as a dependent by his parents, which may reduce the tax advantages of employing the child.
The child can earn up to the standard deduction without paying any taxes. However, up to another $6,000 can be sheltered from taxes by having the child contribute to a traditional IRA.
Even greater tax savings can be achieved by having the child contribute to a 401(k), for 2019, up to $19,000 annually. The employer can contribute up to 25% of the child's wages in addition to what the child contributes or the employer can provide profit-sharing contributions, but the total contribution cannot be greater than $56,000. Note, however, that there are wage limitations to the contributions and the wages paid must be reasonable considering the amount and type of work and the skill level required to perform the job.
Although there may be some concern about having so much money tied up in a retirement account at such a young age, there are some possibilities that can make this election more palatable. When the child leaves employment, the 401(k) can be rolled over into an IRA, which allows the withdrawal of funds for special purposes free of penalties, even before the age of 59½, such as educational expenses, medical expenses, and up to $10,000 to buy a 1st home.
Employing the Spouse
Employing the spouse does not have the same tax advantages as employing dependent children, but there are some. However, the spouse must be paid a bona fide wage and receive a W-2 form at the end of the tax year. Also, the tax advantages may be considerably lessened if the business owner makes more than the Social Security wage base, since dividing the income between the 2 spouses will subject more of that income to the Social Security tax, unless the wages paid to the spouse is less than what the business owner earns above the Social Security wage base, which, in 2019, was $132,900.
A health reimbursement arrangement (HRA), which is a program where the business reimburses its employees for medical expenses, offers excellent tax savings, but a sole proprietor cannot participate. However, the spouse can participate and if the plan specifically allows medical reimbursements for the expenses of the employee, spouse, and dependents, then the business owner is covered. The HRA saves both marginal taxes and self-employment taxes. The business owner must fund the HRA, which is tax deductible, and the money is income- and payroll-tax-free income to the employee.
The other advantage of employing the spouse is that she can contribute to an employer-sponsored retirement plan, which can add significantly to the funds available for retirement for both the business owner and the spouse. Contributions of up to an additional $56,000, or $61,500 if the spouse is at least 50 by year-end, per year can be made if the spouse earns enough.
As with employing the spouse, the tax benefits of employing parents is not as good as hiring dependent children, but there are some advantages over regular employees. Federal unemployment tax does not have to be paid on their wages, which is equal to 6% of the 1st $7000 of the employee's wages, yielding $420 in tax savings per employed parent.
If the business owner is supporting her parents, then significant tax savings can be had if they can work for the business and receive wages, which would be tax deductible for the business. Even if the parents are richer, if the parents are in a lower tax bracket and do not spend the money, then the parents can return the money to the business owner as an annual tax-free gift or as a bequest.