Employing a Family Member
One of the best ways to save on business taxes is to employ a family member. Learn more about the IRS tax rules surrounding this topic in this TaxBuzz Guide.
As noted, one way of reducing the overall family tax bite is to employ family members in the owner’s business. This will allow income to be shifted to the family members and possibly provide them with employment benefits.
Employing a Child
By employing a child, the income tax advantages include obtaining a business deduction for a reasonable salary paid to that child and reducing the self-employment income and tax of the parents (business owners) by shifting income to the child. Since the salary paid to a child is considered earned income, it is not subject to the “Kiddie Tax” rules that apply to children through age 18 and full-time students ages 19 through 23. The Kiddie Tax won’t apply at all to the 19- through 23-year-old student who has earned income that exceeds one-half of his or her total support, another incentive to employ a child in some situations.
The maximum standard deduction available to the child in 2022 is $12,950 (up from $12,550 in 2021). Therefore, the standard deduction eliminates all tax on that amount of the child’s compensation income.
Example 1: A parent is in the 25% tax bracket and owns an unincorporated business. The parent hires their 17-year-old child (who has no investment income) and pays the child $12,950 for the year. The parent reduces their business income by $12,950, which saves the parent $3,238 of income tax (25% of $12,950), and if subject to SE tax, will also have a tax saving on SE tax. The child has a taxable income of $0, $12,950 less the $12,950 standard deduction, resulting in zero income tax for the child.
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If the business is unincorporated, wages paid to the child under age 18 are not subject to social security taxes. Not only are there significant income tax advantages to employing the child, but the parent-employer may provide the child with fringe benefits, such as group-term life insurance and qualified pension plan contributions.
The child may also make deductible contributions to a traditional IRA for 2022 of the lesser of earned income or $6,000. By combining the standard deduction and the maximum deductible IRA contribution, a child could earn $18,950 of wages and pay no income tax. If the child balks at contributing his or her hard-earned money to an IRA, the parent might consider giving the child part or all of the IRA contribution as a gift.
Employing a 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. These wages are subject to income tax.
Reasonable and Necessary
Please keep in mind that when a family member is employed in a family business, the wages should be reasonable for the work performed and that the services performed are necessary to the business.