Family Matters: Tax Issues & Family Employees
If you are the owner of a small business, employing your children may help reduce both your family’saggregate income subject to taxation and the effective rate at which that income is taxed. Whether you are running your business as a corporation, partnership,or sole proprietorship, putting a family member on your payroll makes that person’s income -- and the costs associated with his or her employee benefits -- deductible business expenses.
As a result, the gross income of your business is lowered. While the total family income may remain essentially the same, the income paid to the family member (assuming he or she is not a spouse) is generally taxed at a lower rate. In addition, certain employee benefits are not taxable to the family member. In effect, the family’s overall tax liability is lowered.
Good News -- Now and Later
Suppose that you have a teenage daughter, Susan, who possesses excellent computer skills. If you directly pay Susan the going rate for maintaining your database, and keep a record of her hours and the work performed, her salary will be tax deductible as a business expense. As long as her wages are less than the standard deduction ($5,800 in 2011), her income will be nontaxable. Income above that amount will be taxed at Susan’s presumably lower tax rate.
On the other hand, imagine that your daughter Susan is still an infant. If Jane, your spouse, works in your business, the cost of childcare while she works will be lessened through the allowable childcare tax credit for such expenses.
Looking forward 20 years, having your wife Jane on the payroll could prove helpful with retirement planning. Your company’s pension plan, or defined benefit plan -- which qualifies under the Employee Retirement Income Security Act (ERISA, amended in 1974) -- allows Jane to receive an annual minimum distribution of $10,000, regardless of whether her annual salary ever got that high. Most importantly, during Jane’s 20 years of service, your business was able to deduct contributions to the plan on her behalf from gross income.
Perhaps your business offers a qualified retirement plan, such as a 401(k) plan. If so, the contributions made by your business to Jane’s account, up to a certain amount, would also qualify as a tax-deductible business expense.
IRAs Are Family-Friendly
If your business does not offer a qualified retirement plan, or if family members like Jane and Susan do not participate in such a plan, then an Individual Retirement Account (IRA) -- available only to employed individuals or their spouses -- is an option. IRA contributions -- limited to $5,000 in 2011or $6,000 for those age 50 and older -- are tax deductible, subject to certain income limits for the employee (but not the business), and allow for tax deferral on earnings until distributions are taken. Distributions taken before the age of 59˝ may be subject to a 10% Federal income tax penalty, as well as ordinary income taxes. Certain exceptions may apply.
Other Benefits
As employees, Jane and Susan are eligible for other employee benefits your company may elect to provide, such as accident and health coverage, group term life insurance,and tuition assistance. The costs of these benefits, assuming they are reasonable, are also deductible business expenses.
Keep in mind that employing family members means they must actually work in the business for compensation that is reasonable for the type of work performed. Be aware that the tax status of any retirement account or plan vehicle (and there are many types) is strictly governed by statutes and regulations that cover both employer and employee. Nonetheless, putting family members on the payroll can often bring home financial and tax benefits. For more information, consult your tax professional.
